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FORM 10-K
UNITED STATE SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) FOR THE
TRANSITION PERIOD FROM TO
COMMISSION FILE NO. 0-21426
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CASINO DATA SYSTEMS
(Exact name of registrant as specified in its charter)
NEVADA 88-0261839
(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) No.)
3300 BIRTCHER DRIVE
LAS VEGAS, NEVADA 89118
(Address of principal executive offices) (Zip Code)
(702) 269-5000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, NO PAR
VALUE
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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 by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. Yes /X/ No / /
As of March 16, 1999, 18,065,897 shares of the Registrant's Common Stock
were outstanding. The aggregate market value of the Common Stock held by
non-affiliates of the Registrant on such date, based upon the last sale price of
the Common Stock as reported on the NASDAQ National Market on March 16, 1999,
was $42,229,597. For purposes of this computation, affiliates of the Registrant
are deemed only to be the Registrant's executive officers and directors.
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TABLE OF CONTENTS
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PART I
Item 1. Business.................................................................................... 3
Item 2. Properties.................................................................................. 24
Item 3. Legal proceedings........................................................................... 24
Item 4. Submission of Matters to a Vote of Security Holders......................................... 26
PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters........................ 26
Item 6. Selected Financial Data..................................................................... 26
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....... 27
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................. 36
Item 8. Consolidated Financial Statements and Supplementary Data.................................... 37
Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosure........... 66
PART III
Item 10. Directors and Executive Officers of the Registrant.......................................... 66
Item 11. Executive Compensation...................................................................... 66
Item 12. Security Ownership of Certain Beneficial Owners and Management.............................. 66
Item 13. Certain Relationships and Related Transactions.............................................. 66
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............................. 66
Signatures.................................................................................. 68
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ITEM 1. BUSINESS
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR"
PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The following discussion contains various "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Sections 21E of the Securities Exchange Act of 1934, as amended, which represent
the Company's expectations or beliefs concerning future events that involve a
number of risks and uncertainties. The actual results of operations of the
Company could differ materially from historical results of operations and those
discussed in the forward-looking statements contained herein. Factors that could
cause actual results to differ materially include, but are not limited to, those
identified in the Sections below entitled, "Technology Risks and Certain Other
Business Risks", "Intellectual Property Rights", "Regulation", "Item 3, Legal
Proceedings" and "Item 7, Management's Discussions and Analysis of Financial
Conditions and Results of Operations." In addition, statements containing
expressions such as "believes," "anticipates," "plans" or "expects" used in the
Company's periodic reports on Forms 10-K and 10-Q filed with the SEC are
intended to identify forward-looking statements. The Company cautions that these
and other forward-looking statements included in this report and in previously
filed periodic reports including reports filed on Forms 10-K and 10-Q are
further qualified by important factors that could cause actual results to differ
materially from those in a forward-looking statement, including, without
limitation, the following: decline in demand for gaming products or reduction in
the growth rate of new and existing markets; delays of scheduled openings of
newly constructed casinos; the effect of economic conditions; a decline in the
market acceptability of gaming; unfavorable public referendums or anti-gaming
legislation; delays or lack of funding from regulatory agencies for gaming
operations; competitive factors, such as improvements in rival player tracking
system functionality or game acceptance, timing of software system products
introductions and upgrades, timely development implementation, production and
customer acceptance of new gaming devices in a cost effective manner, execution
of the manufacturing ramp, the ability to successfully enter new market segments
and manage the growth of such businesses, unanticipated costs or other adverse
effects of changes in the gaming industry, a decrease in the desire of
established casinos to upgrade machines in response to added competition from
newly constructed casinos; changes in player appeal for gaming products; pricing
pressures; changes in interest rates causing a reduction of investment income;
loss or retirement of key executives; approval of pending patent applications or
infringement upon others' existing patents; the effect of regulatory and
governmental actions; unfavorable determination of suitability by regulatory
authorities with respect to officers, directors or key employees; the
limitation, conditioning or suspension of any gaming license; year 2000 issues;
the discovery of facts not presently known to the Company or determinations by
judges, juries or other finders of fact which do not accord with the Company's
evaluation of the possible liability or outcome of existing litigation, and
other risk factors identified from time to time in the Company's SEC filings.
GENERAL
Casino Data Systems (the "Company" or "CDS") is a designer and manufacturer
of innovative technology-driven products for the gaming industry. The Company's
primary products and services include the (i) design and manufacture of casino
management information systems, including the Company's historical core product,
the OASIS-TM- II (On-Line Accounting and Slot Information System) System and its
successor, OASIS Windows-Registered Trademark- (Windows is a registered
trademark of Microsoft Corporation) (collectively referred to as "OASIS"); (ii)
operation of multi-site link progressive ("MSP") systems which link gaming
machines in different casinos to allow patrons to compete for large,
lifestyle-changing progressive jackpots; (iii) design and manufacture of
innovative gaming machines and (iv) design and manufacture of meters, signs and
graphics which allow the Company to offer integrated gaming systems with custom
designed glass and graphics, progressive meters and customized overhead signage.
The Company provides these products and services through operation of five
segments: systems and services, games, recurring revenue products,
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signs and software. Prior to 1998, the Company also operated an additional
graphics and imaging segment that sold graphics and imaging products to third
parties.
These segments contributed to consolidated revenue for each of the three
years ended December 31, 1998 as follows:
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REVENUES
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SEGMENT 1998 1997 1996
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(DOLLARS IN THOUSANDS)
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Systems and Services......................................... $ 23,147 $ 19,314 $ 36,156
Games........................................................ 14,561 6,328 2,432
Recurring Revenue............................................ 9,469 21,127 23,703
Signs........................................................ 4,031 4,244 3,754
TurboPower................................................... 1,847 1,450 1,341
Graphics and Imaging......................................... 125 2,041 3,485
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Total.................................................... $ 53,180 $ 54,504 $ 70,871
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Founded in 1990 by Steven Weiss, the Company's Chairman and Chief Executive
Officer, the Company grew rapidly by developing and marketing technologically
advanced products, including its DOS based OASIS casino management information
systems and its Cool Millions-TM- MSP system, and through strategic acquisitions
of businesses and technology to complement the Company's core products. Since
their introduction in 1991, the Company's OASIS systems have been installed in
over 117,000 gaming machines in approximately 90 casinos throughout North
America. Through the marketing and enhancement of its OASIS systems, the Company
has developed relationships with many major casinos in North America, which the
Company believes provides it with a competitive advantage in marketing its other
products and systems. In 1993, the Company developed progressive meter
technology and has since expanded and diversified its operations through the
acquisition of graphics, signs and software businesses. In 1994, the Company
launched its Cool Millions MSP system in Mississippi and was licensed by Nevada
as a manufacturer and distributor of gaming devices. The Company currently has
approximately 50 proprietary video poker games, 5 proprietary video slot games,
11 traditional reel spinning slot machines and 5 "tophat" reel spinning slot
machines (tophat games are traditional reel spinning slot machines with an
additional wheel apparatus which is used primarily for bonusing features) for
general sale in various jurisdictions.
BUSINESS STRATEGY
The Company's objective is to become the leading designer and manufacturer
of innovative technology-driven products and services to meet the gaming
industry's evolving needs into the next century. To meet this goal, the Company
intends to continue to enhance and refine its existing products and systems,
develop new and entertaining interactive gaming devices and continue its
research and development efforts to maintain its ability to offer
technologically advanced products in each of its businesses and further
integrate its operations to provide the best possible products and services to
its customers. The Company also continually reviews all components of its
business for possible improvement of future profitability and shareholder value
through acquisition, divesture, reengineering or restructuring. In the fourth
quarter of 1997, the Company developed and initiated a restructuring plan
designed to improve the Company's cost structure, streamline operations and
divest the Company of underperforming assets. Implementation of the plan
resulted in certain asset impairment and losses in 1997. Although the
restructuring plan had a materially adverse affect on the 1997 results of
operations, management believes that the plan was necessary in order for the
Company to have the ability to achieve the greatest possible profitability in
the future. The key elements of the Company's strategy are described below in
relation to the Company's lines of business.
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BUSINESS SEGMENTS
SYSTEMS AND SERVICES
CASINO MANAGEMENT INFORMATION SYSTEMS
In order to maintain its position as a technological leader, the Company is
continuing to expand the functionality of its casino management information
system. The Company believes that sophisticated and reliable information systems
will be a key element in the continued growth and success of the gaming
industry. The Company's slot accounting and player tracking systems
traditionally have been used by casinos to monitor play and to collect,
integrate and analyze data from slot machines, MSP systems, video poker machines
and other electronic gaming devices. The Company is expanding its slot
accounting and player tracking system into a casino-wide management information
system by using its technological expertise to develop software modules that
allow the OASIS system to support additional casino marketing, accounting,
security and maintenance functions. OASIS products introduced include
Surveillance Monitor-TM-, Maintenance Monitor-TM-, SlotHOST-TM-, RapidPAGE-TM-
OmniVIEW-TM-, PitBoss-TM- and ProTURBO-TM-. In addition, the Company has
wireless radio frequency communication capability in its OASIS system. The
Company has completed development of a Windows-Registered Trademark- and a
Windows NT compatible version of OASIS. The development of these system
enhancements enable OASIS to improve communications and data exchange with the
customer's hotel and other information management systems. Customers have the
ability to customize their casino management information systems by adding new
modules and features to their existing OASIS systems as expansions or upgrades.
The Windows compatible version of the OASIS system was completed and
approved for field trial in Nevada in April 1998. The Windows compatible version
utilizes NT Server operating software and incorporates all existing OASIS
modules, Microsoft SQL Server relational database and third party report
generators. The Windows compatible version was approved for general sale in
Gaming Laboratories International, Inc. ("GLI" is an independent gaming
consultant that many jurisdictions utilize to approve electronic gaming devices,
systems and associated equipment) territories in October 1998 and completed its
field trial and was approved for general sale in Nevada in November 1998.
OASIS, the Company's on-line accounting and player tracking system, forms
the core of the Company's casino management information system. The Company's
casino management information systems are comprised of modular software
applications designed to deliver real-time solutions to the gaming industry. The
system uses advanced electronic monitoring equipment to collect, integrate,
analyze and report data from traditional slot machines, multi-site progressive
link machines, video poker and other electronic games. By linking on-line slot
accounting and player tracking information, the OASIS system allows casinos to
perform sophisticated and customized data analysis in real-time.
BlackBart-TM-, the on-line slot accounting feature of the OASIS system,
continuously records each coin that enters, exits, or is retained by each
electronic gaming machine, monitors all jackpots and fills and calculates coin
and currency drop values. This information is rapidly and continuously
communicated to generate instant or "on-line" accounting of revenues and net win
to casinos for all types of electronic gaming machines. An automated jackpot and
fill program provides comprehensive jackpot accounting, security and control,
including support for the Company's ProTURBO line of progressive jackpot meters,
automatic federal and state tax withholding and automatic updates to the player
tracking system. The ProTURBO central controller provides cost and operational
advantages by eliminating individual controllers for each meter and by enabling
casinos to control all meters from one central workstation, allowing casinos to
reset meters without manually configuring each meter on the casino floor.
Super-PlayMate-TM-, the player tracking and marketing database feature of
the OASIS system, allows casino operators to collect and access real-time player
marketing information. Casino marketing departments use OASIS system data to
engage in target marketing, measure customer response to marketing efforts,
award "comps" to good customers and to measure the cost effectiveness of various
"comp" and
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marketing programs by comparing the expenditures with revenues generated by a
player or group. To collect player information, casinos issue to slot players
coded and individualized "slot club" cards which are inserted into a card reader
mounted on or in the slot machines. The OASIS system records the length of play,
amount bet and casino win on each machine played, enabling the casino to keep a
record of gaming activity for each customer. In addition, the OASIS system can
integrate manually-entered table game data with slot machine readout to produce
combined player ratings.
The OASIS system features OmniVIEW, a dynamic, real-time graphic
representation of the electronic gaming floor, which provides a record of all
gaming activity as it occurs. By moving a cursor around the floor plan, the user
can obtain detailed current information about any slot machine and any player.
Also included is a quarter-hour trend analysis that provides 15 minute snapshots
of casino player activity, trend activity reports for carded and uncarded
players, machine utilization and coin-in, coin-out information to help identify
trends.
The OASIS system's SlotHOST module utilizes a small hand-held portable
device to provide real-time player information to users on the casino floor,
alerting casino management to high activity players and helping casinos
personalize their marketing. In addition, the Surveillance Monitor module is
designed to assist security and surveillance personnel by flagging certain types
of transactions with distinctive message or alarm attributes, while the
Maintenance Monitor-TM- module provides a lifetime history of maintenance
problems and procedures for each gaming machine and can be programmed to
automatically page maintenance personnel and trigger work orders when certain
failure codes are entered via keypad.
The Company continues to invest in its OASIS casino management information
systems to pursue its objective of technological leadership in the industry. The
Company will continue to enhance existing modules and develop new modules in the
future.
GAMES
VIDEO INTERACTIVE GAMING MACHINES
The Company has developed a proprietary video interactive gaming machine
platform which supports high-speed, high resolution video displays and
CD-quality stereophonic sound with advanced memory and graphics capabilities. As
a result of its advanced platform, the Company is able to develop gaming devices
which automatically adjust the speed of its graphics displays to match the
player's speed of play, providing more rapid dealing action for fast players.
The Company intends to develop additional interactive video gaming machines
based on this platform and to develop more advanced platforms that will support
additional graphics, animation, and other secondary game features designed to
increase the entertainment value and interactivity of video gaming.
The Company believes that its success in the video gaming business will be
dependent upon its development and marketing of state-of-the-art interactive
video gaming machines which will add entertainment value and encourage social
interaction among players to enhance the gaming experience. To that end, the
Company has developed approximately 50 video poker games, 5 video slot games and
one Bandit-TM- game (see below) that are currently licensed in certain
jurisdictions. In addition, the Company intends to develop new interactive video
gaming devices with enhancements in production value, computer graphics and
entertainment-focused secondary game features.
The Company's first game available from its Bandit series of games is the
Bandit Bingo game. The Bingo game is a five-reel video slot machine based on a
bingo game. Bingo was approved for general sale in New Jersey in November 1998
and in GLI territories in December 1998. It is expected to be approved in Nevada
by early second quarter 1999.
In November 1996, the Company entered into an agreement with Prolific
Publishing, Inc. ("Prolific") for the development of art to be primarily used in
several innovative and interactive gaming machines collectively referred to as
the Bandit series. In September 1998, the Company purchased an application
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program interface ("API"), game engine and various furniture, fixtures and
office equipment from Prolific for $1.625 million. In addition, the transaction
released the Company from its obligation to pay royalties to Prolific on sales
of its Bandit games. The Company also announced that it hired 12 of Prolific's
technical and managerial personnel.
REEL SPINNING SLOT MACHINES
The Company owns a fully paid license for Telnaes technology. The Telnaes
technology can be used in reel spinning slot machines to enable the Company to
create the high odds necessary to allow large progressive jackpots. The Company
intends to continue to use Telnaes technology in its design and manufacture of
reel spinning slot machines for general sale to casino customers and for use in
its MSP systems. The Company believes that currently only a small number of
entities have the right to use the Telnaes technology to produce traditional
reel spinning slot machines. In addition, the Company also intends to continue
to use its position as an innovative designer of gaming technology to produce
reel spinning slot machines incorporating advanced graphics and innovative
secondary game features. The first of which was the Company's Safe Buster-TM-
game. Safe Buster, jointly marketed by the Company and Anchor Gaming, features a
three reel spinning slot machine with a prominent back-lit safe dial which, when
matched to a random three number combination, can "crack" a mythical safe
containing a jackpot payout. To meet the gaming industry's evolving needs the
Company will seek to distinguish itself from other manufacturers by offering
customized interactive games that offer increased entertainment value.
RECURRING REVENUE PRODUCTS
MSP systems link a number of gaming machines in various casinos to a central
computer that allocates a portion of each wager made to one or more progressive
jackpots. By linking the machines together, larger life-style changing
progressive jackpots can be awarded more frequently than with stand alone
machines due to the increased number of wagers contributing to the jackpot on
the link. The Company had 556 games participating on its four MSP system links
as of December 31, 1998.
The Company introduced its first Cool Millions system in Mississippi in
November 1994. Cool Millions is a traditional three-coin, three-reel spinning,
dollar slot machine. Cool Millions offers a large primary progressive jackpot
and a smaller more frequent secondary progressive jackpot. Cool Millions differs
from competing MSP systems by offering an immediate cash pay out of one million
coins on the primary jackpot (i.e., the base component) with the balance of the
jackpot paid out as an annual annuity (i.e., the progressive component). The
Mississippi Cool Millions dollars link was terminated in March 1998 due to
decreased play. The meter increment amount was allocated to the Mississippi Cool
Millions quarters link.
The Company introduced its Cool Millions quarters, a quarter denomination
version of Cool Millions, in Nevada in April 1996 and in Mississippi in June
1996. The Company's Cool Millions quarters MSP systems features a million coin
($250,000) initial payment on the primary jackpot, with the balance of the
jackpot paid out as an annual annuity. The Company terminated the Mississippi
Cool Millions Quarters link in March 1999 due to decreased play. The Company is
awaiting a ruling by the Mississippi Gaming Control Board regarding the
treatment of the unpaid Cool Millions quarter link jackpot prize remaining at
the time the link was terminated.
The Company introduced both its Cool Millions and Cool Millions quarters
games in Native American lands in August 1996. Due to decreased play, the
Company terminated the dollar denomination portion of the Cool Millions link in
Native American lands in February of 1998. At the time of termination, there was
no unpaid jackpot prize. The Company also terminated the Cool Millions quarters
link in Native American lands in October 1998 due to decreased play. The Company
transferred the Cool Millions quarter meter increment to the Native American
Xtreme Jackpots link meter.
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In launching its Cool Millions system, the Company depended upon a single
manufacturer to supply it with slot machines. Because the Company did not
manufacture the Cool Millions games, the Company could not modify the games to
respond to shifts in player appeal or competitive pressures which resulted in
declining interest and erosion of product performance. As a result, in the
fourth quarter of 1997, the Company decided to liquidate the Cool Millions
assets through third party brokers and replace them with assets produced by the
Company. As a result, the Company recognized a $9,548,000 restructuring charge
to income from operations in the fourth quarter of 1997 to reduce the Cool
Millions assets to the their estimated net realizable value. The Company intends
on only using gaming devices manufactured by the Company for future expansion of
its MSP operations. Throughout 1998, the Company liquidated these Cool Millions
assets for prices at or slightly greater than their book values. As of December
31, 1998, assets with book value of approximately $19,000 remain in operation.
Management expects to liquidate these remaining Cool Millions assets in 1999 and
does not expect to recognize any loss on disposal.
In pursuit of its strategy to deploy its own manufactured games on MSP
links, the Company introduced its Xtreme Jackpots link in Nevada during April
1998. The Xtreme Jackpots progressive is the first to feature video slot games
styled along the lines of the increasingly popular multi-line, multi-coin video
games. Xtreme Jackpots is also the first multi-site progressive link to connect
multiple denominations of games to the same jackpot which, in Nevada, starts at
$500,000 and can be won by playing the maximum bet of $1.25 in either quarter or
nickel denominations. The primary jackpot is paid out over 20 equal annual
payments. The Company also introduced the Xtreme Jackpots link in Native
American lands in October 1998. The primary jackpot begins at $250,000 for the
Native American Xtreme Jackpots link and is paid out equally over 20 annual
payments.
SIGNS
The Company believes that single, integrated product installations offer
customers a cost-effective product and are the most efficient marketing strategy
for the Company's meter and sign products. The Company intends to promote the
marketing of product packages including overhead signage, in-machine and
overhead progressive meters.
The Company has developed a full line of progressive meters, controllers and
progressive systems. A meter is a graphics display device for progressive
jackpots which displays current jackpot size to gaming patrons. The Company's
ProVIEW-TM- family of meters offers in-machine and overhead text messaging,
odometer jackpot effects and graphic animation sequences. The meters are
available in various sizes, configurations and resolutions. A controller is a
data transmission device that links gaming machines and meters into a
progressive system. The Company's ProLINK-TM- line of controllers allows
operation of proprietary progressive systems within one or more of a casino
operator's properties. A progressive system is comprised of meters and
controllers that link together slot machines, allocates a portion of each wager
to a progressive jackpot and displays the current jackpot size via overhead or
in-machine displays. The Company's ProSOLO one-machine progressive system
enables a single slot machine to offer a progressive jackpot. The Company's
ProTURBO progressive system links the ProLINK progressive technology with the
OASIS II system to create a single, highly-flexible controller that manages both
progressive communications and player tracking/slot accounting data collection.
The ProTURBO system allows the casino operator to customize or change any of the
meter-linked signs from a single networked work station, compared with competing
meter-linked signs that must be changed one at a time from the casino floor. In
1998, a competitor of the Company filed two lawsuits alleging that ProTURBO
violates certain patent rights of the competitor. The Company believes that
these actions are without merit. See additional discussion in Item 3. Legal
Proceedings.
SOFTWARE DEVELOPMENT TOOLS
The Company's TurboPower Software subsidiary (TurboPower) develops advanced
software programming tools used by software professionals to develop
applications for business and industry. In the fourth
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quarter of 1997, the Company committed to a plan to sell the TurboPower Software
subsidiary after concluding that TurboPower no longer fit within the Company's
overall market strategy. Based on an estimate of future cashflows and the
estimated fair value of its assets, the Company adjusted the book value of
TurboPower's assets down to their fair value which resulted in a charge of
$983,000 in the fourth quarter of 1997. Due to TurboPower's stronger financial
performance in 1998 and to recent changes in various executive positions within
the Company, current management now believes that TurboPower will be an
important component of the Company's future success. Based on this, current
management discontinued its search for purchase candidates for TurboPower in the
fourth quarter of 1998 and reclassified these assets back to operating status.
GRAPHICS AND IMAGING
The Company's Graphics and Imaging subsidiary designed and manufactured
decorative flat glass and slot reel graphics, supplying the Company's MSP system
operation and video interactive games division as well as outside slot machine
manufacturers and casinos. Due to losses reported for several consecutive
quarters, the Company initiated a plan in the fourth quarter of 1997 to
restructure CDS Graphics and Imaging. The plan consisted mainly of discontinuing
external operations and servicing only internal demand which resulted in a
reduction of personnel of 23 employees and the planned disposition of equipment
and inventory. The planned restructuring of CDS Graphics and Imaging resulted in
a restructuring charge to income from operations in the fourth quarter of 1997
of $2,163,000 representing the amount required to write CDS Graphics and
Imaging's assets down to their fair value. The Company will continue to design
and manufacture decorative flat glass and slot reel graphics for the Company's
MSP system operation and video interactive games division.
TECHNOLOGY AND CERTAIN OTHER BUSINESS RISKS
RISKS OF NEW AND EXPANDING BUSINESSES; RAPIDLY CHANGING TECHNOLOGY
The Company is continuing to expand and diversify its business by developing
and introducing new products that complement and enhance the Company's existing
businesses. The Company faces the risks, expenses and difficulties frequently
encountered by new and rapidly expanding businesses, including, but not limited
to, fluctuating cash flow, initial high development costs of new products
without corresponding sales, pending receipt of regulatory approvals and market
introduction and acceptance of new products. Of course, there is no assurance
that the Company's new products will be accepted in the marketplace or that
regulatory approvals will be obtained. Furthermore, in each area of the
Company's business, the Company will need to manage the transition to higher
volume operations, entry into new markets, control of overhead expense and the
addition, training and management of qualified personnel.
The Company's development as a gaming machine manufacturer and supplier is
dependent upon numerous factors, including its ability to design, manufacture,
market and service gaming machines that achieve player and casino acceptance
while maintaining product quality and acceptable margins. The Company must
compete against gaming machine suppliers with greater financial resources, name
recognition, established service networks and customer relationships. The
Company believes that it will need to develop gaming machines that offer
technological advantages or unique entertainment features in order for the
Company to be able to compete effectively in the gaming machine market.
TIME TO MARKET
Each area of the Company's business is characterized by rapidly changing
technology and frequent new product introductions and enhancements. The
Company's success will depend in part on its ability to continue to enhance its
existing products and to introduce in a timely manner new products that meet
evolving customer requirements and achieve market acceptance. There can be no
assurance that the Company will be successful in identifying, developing and
marketing new products or enhancing its existing
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products. The Company's business will be adversely affected if the Company
experiences delays in developing new products or enhancements or if such
products or enhancements do not gain customer acceptance.
FACTORS AFFECTING PROFITABILITY AND GROWTH
Substantially all of the Company's revenues and profits are derived from the
gaming industry. The continued profitability and growth of the Company's
business is substantially dependent upon factors that are beyond the control of
the Company, including, among others, the pace of development, expansion and
renovation of casinos, the legalization of MSP systems and other forms of casino
gaming in new jurisdictions, the continued popularity of casino gaming as a
leisure activity and increased demand by gaming customers for progressive
jackpot games and game variations providing increased payout opportunities. The
expansion of the gaming industry has slowed in recent years and the continued
expansion of gaming markets is dependent upon political, legal and other factors
which are beyond the control of the Company. As a result of these and other
factors, there is no assurance of the Company's continued growth or
profitability.
RELIANCE ON KEY CUSTOMERS
The Company has historically maintained strong business relationships with
several key casino customers including, but not limited to, Boyd Gaming; Circus
Circus Enterprises; Foxwoods; Park Place Entertainment Corporation, successor to
Grand Casinos; Mirage Resorts; Showboat and Station Casinos which have, in
certain periods, accounted for a material amount of the Company's sales. These
entities accounted for approximately 25%, 36% and 33% of the Company's total
sales during the fiscal years ended December 31, 1998, 1997 and 1996,
respectively. While each sale of casino management information systems and other
large product contracts are negotiated independently and do not occur with
specific frequency, the loss or reduction of a major customer could have a
material adverse impact on the financial results of the Company. There can be no
assurance that the Company will maintain strong business relationships with its
key customers in the future.
COMPETITION
The market for casino management information systems, MSP systems, gaming
machines and each of the Company's other products are difficult markets in which
to compete and there are a number of established, well-financed and well-known
companies that compete with each of the products and services offered by the
Company. IGT in particular enjoys a significant domestic and international
market position in the Company's primary markets, including casino management
information systems, gaming machines and MSP systems. The Company has
established a meaningful market share in casino management information systems
in North America and modest market penetration in multi-site progressives within
Nevada, Mississippi and on Native American lands.
The Company also competes with several other competitors in one or more
areas of the Company's markets, including Alliance Gaming (Bally Gaming
International), Anchor Technologies, Sigma Gaming, Universal Distributing,
Mikohn, WMS Gaming, Acres Gaming, Silicon Gaming, Aristocrat, Atronic, Unidesa,
Gaming Systems International, Lodging Systems, Inc. and Yesco. The development
of a successful new product or product design by a competitor could adversely
affect sales of the Company's products and, although the Company would endeavor
to respond quickly with its own competing products, no assurance can be made
that a significant new product designed by a competitor would not have a
material adverse effect on the Company's results of operations.
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MARKETING AND SALES
The Company has approximately 34 full time sales and marketing staff
focusing on the sales of OASIS casino management information systems, MSP games,
games, signs and meters. The Company's TurboPower Software subsidiary sells its
products primarily by telephone and the Internet. In addition to its corporate
headquarters in Las Vegas, Nevada, the Company maintains regional sales and
support offices in Sparks, Nevada, Gulfport and Tunica, Mississippi; Atlantic
City, New Jersey and Plymouth, Minnesota.
INTELLECTUAL PROPERTY RIGHTS
The Company's business is dependent upon its ability to protect its
proprietary software, hardware and other intellectual property. The Company
relies primarily on a combination of non-disclosure agreements for its key
employees and other third parties, license agreements and nondisclosure
agreements with its customers and suppliers and trade secret protection to
protect such intellectual property. Despite the Company's precautions, it may be
possible for unauthorized parties to copy or to possibly reverse engineer
certain portions of the Company's products or to obtain and use information that
the Company believes is proprietary. Therefore, there is no assurance that
precautionary steps taken by the Company in this regard will be adequate to
deter misappropriation of its intellectual property or independent third party
development of functionally equivalent products or that the Company can
meaningfully protect its rights to such proprietary intellectual property. The
Company has applied for patents covering certain aspects of its MSP systems and
gaming devices. There is no assurance that such patents will be issued, or, if
issued, will offer meaningful protection of such intellectual property. In
addition, whether or not such patents are issued, others may hold or receive
patents which contain claims having a scope that covers products developed by
the Company. Furthermore, there can be no assurance that others have not
developed or will not develop similar products or technology, duplicate any of
the Company's products or technology, or design around any patents licensed or
granted to the Company, or any patents that may be issued in the future to the
Company.
EMPLOYEES
As of December 31, 1998, the Company had approximately 385 full-time
employees, approximately 70 of whom were software or hardware engineers. The
majority of the remaining employees are engaged in technical support and
customer service, production, field installation and support, sales and
marketing and administration. The Company also uses a temporary agency to
provide skilled workers for light manufacturing and assembly during high-demand
manufacturing periods. The Company is not currently subject to a collective
bargaining agreement and believes that its employee relations are good.
REGULATION
OVERVIEW
The Company is subject to regulation in jurisdictions in which it operates
MSP systems and in most jurisdictions in which its products are sold or are used
by persons or entities licensed to conduct gaming activities. Such gaming
regulations vary from jurisdiction to jurisdiction and the classification and
level of the regulatory licensing, approvals and compliance to which the Company
and its products must conform also vary by jurisdiction. In certain
jurisdictions, the Company or its subsidiaries may be operating pursuant to
temporary waivers or approvals. There can be no assurance that such temporary
waivers or approvals will be maintained or become permanent. Failure by the
Company or its subsidiaries to obtain, or the loss or suspension of, any
necessary licenses, approvals or suitability findings would prevent or restrict
the Company or its subsidiaries from operating, selling or distributing its
products in most jurisdictions, which would have a material adverse effect on
the Company. In the event gaming authorities determine that an officer,
director, key employee, stockholder or other person of the Company is unsuitable
to act in such a capacity, the Company will be required to terminate its
relationship with such person, which termination
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could have a material adverse effect on the Company. Although the Company has
the right to redeem shares of an unsuitable stockholder under certain
circumstances, such a finding of unsuitability could in any event have a
material adverse effect on the Company. There can be no assurance that the
Company or its subsidiaries will obtain all the necessary licenses and approvals
or that its officers, directors, key employees, their affiliates and certain
other stockholders will satisfy the suitability requirements in each
jurisdiction in which the Company or its subsidiaries seeks to operate MSP
systems or in which its products are sold or used by persons licensed to conduct
gaming activities. The failure to obtain such licenses and approvals in one
jurisdiction may affect the Company's licensure and/or approvals in other
jurisdictions. In addition, a significant delay in obtaining such licenses and
approvals could have a material adverse effect on the business prospects of the
Company.
The Company's OASIS casino information management systems and related
meters, controllers and progressive systems are generally classified as
"associated equipment." "Associated equipment" is equipment that is not
classified as a "gaming device," but which has such an integral relationship to
the conduct of licensed gaming that regulatory authorities have discretion to
require suppliers of such systems to meet licensing suitability requirements
prior to or concurrent with the use of such equipment in the respective
jurisdiction. Associated equipment generally must be approved in advance by the
regulatory authorities for its use at licensed locations within the
jurisdiction. The Company or its distributor has complied in all material
respects with the associated equipment approval process in each jurisdiction in
which it has sold OASIS systems.
The gaming machines that may be developed by the Company are defined as
"gaming devices." Although gaming device and equipment regulations vary among
jurisdictions, each jurisdiction requires various licenses, approvals or permits
to be held by companies and their key personnel in connection with the
manufacture and distribution of gaming devices and equipment. The Company or one
of its subsidiaries is licensed as a manufacturer, distributor and/or supplier
of gaming devices in the states of Iowa, Louisiana, Mississippi and Nevada,
certain Native American jurisdictions and the city of Windsor, Ontario, Canada,
and has applied to be licensed in several other jurisdictions. The Company has
operated pursuant to transactional waivers or as a supplier of associated
equipment in jurisdictions in which the Company's license applications are
pending. The Company will be required to apply for additional transactional
waivers in the event it seeks to make sales to additional casinos in such
jurisdictions prior to licensing. The Company will be required to apply for
licensing as a manufacturer, distributor and/or supplier of gaming devices or
associated equipment prior to making sales in each new jurisdiction.
As an operator of MSP systems, the Company, certain of its officers,
directors, key employees, stockholders and other affiliates are subject to
mandatory operator licensing and approval requirements, operator suitability
requirements and ongoing regulatory oversight in each jurisdiction in which it
operates MSP systems. On October 28, 1994, CDS Gaming received a gaming operator
license from the Mississippi Gaming Commission. On December 21, 1995, CDS Gaming
was licensed by the Nevada Gaming Commission as an operator of an inter-casino
linked system ("OILS"). The OILS license permits the Company to operate MSP
systems without being licensed to conduct gaming at each Nevada casino
participating in the MSP system. There can be no assurance that the Company or
its subsidiaries will obtain all of the necessary licenses and approvals or that
their officers, directors, key employees, other affiliates and certain other
stockholders will satisfy the suitability requirements in one or more
jurisdictions, or that such licenses, approvals and suitability findings, if
obtained, will not be revoked or not be renewed in the future. The laws,
regulations and procedures pertaining to gaming are subject to the
interpretation of the Regulatory Authorities and may be amended. Any changes in
such laws, regulations, or their interpretations could have a material adverse
effect on the Company.
GENERAL REGULATION OF STOCKHOLDERS OF PUBLICLY TRADED CORPORATIONS
In most jurisdictions, any beneficial owner of the Company's Common Stock is
subject on a discretionary basis to being required to file applications with
gaming regulatory authorities, be investigated
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and found suitable or qualified as such. In addition, stockholders whose
holdings of Common Stock exceed certain designated percentages are subject to
certain reporting and qualification requirements imposed by state and federal
gaming regulators and, any stockholder, if found to be unsuitable, may be
required to immediately dispose of its holdings of Common Stock. See "--New
Jersey Regulatory Matters," "--Nevada Regulatory Matters" and "--Mississippi
Regulatory Matters." The Company's Articles of Incorporation authorize the
Company to redeem at fair market value Common Stock held by any person whose
status as a shareholder may jeopardize the Company's gaming licenses or
approvals.
NEW JERSEY REGULATORY MATTERS
Casino gaming in New Jersey is regulated by the New Jersey Casino Control
and regulations promulgated thereunder (the "NJCCA"). The NJCCA created the New
Jersey Casino Control Commission ("NJCCC"), which is authorized to decide all
license applications and other matters and to promulgate regulations, and
created the New Jersey Division of Gaming Enforcement (the "NJDGE"), which is
authorized to investigate all license applications, make recommendations to the
NJCCC, and prosecute violations of the NJCCA. Under the NJCCA, any enterprise
providing goods or services to a casino must register with or be licensed by the
NJCCC.
Business enterprises providing goods and services not directly related to
casino gaming or simulcast wagering must be registered with the NJCCC within 20
days of commencing business with the casinos and must be licensed by the NJCCC
if they conduct business with casinos on a regular or continuing basis, the
NJCCC will consider various factors, including the amount of business
transacted. Currently, any enterprise which transacts more than $75,000 in
business with any one casino in any one 12-month period or more than $225,000
with all casinos of Atlantic City within any one 12-month period or more than
$30,000 with one casino within each of three consecutive 12-month periods or
more than $100,000 with the casinos of Atlantic City within each of three
consecutive 12-month periods must be licensed.
Business enterprises providing goods or services directly related to casino
gaming or simulcast wagering must be licensed as a gaming related Casino Service
Industry ("CSI") prior to conducting business with New Jersey casino licensees
or must have filed a complete application for CSI licensure with the NJCCC and
received the permission of the NJCCC for each business transaction.
On November 4, 1996, the Company was granted a Casino Service Industry
License by the NJCCC. In order for this license to be maintained, the Company's
officers, directors and key employees and all beneficial owners of more than
five percent (5%) of the Company's Common Stock must be found qualified by the
NJCCC. In order to be found qualified, the Company, its officers, directors, key
employees and five percent (5%) stockholders must demonstrate by clear and
convincing evidence their good character, honesty and integrity, their financial
stability, integrity and responsibility, and their business ability. Any other
stockholder or other person associated with the Company who the NJCCC deems
appropriate, in its discretion, is also required to be qualified. If a person is
required to and fails to submit to qualification or submits to qualification and
is found disqualified by the NJCCC, the NJCCC may prohibit casinos in New Jersey
from doing business with the Company. While the investigation by the NJDGE is
pending, there is no assurance that the Company or any of its directors,
officers, key persons or five percent (5%) shareholders will be found qualified
or suitable for licensure.
However, "institutional investors" (as defined in the NJCCA) may be granted
a waiver of the requirement to be found qualified by the NJCCC. An institutional
investor includes any retirement fund administered by a public agency for the
exclusive benefit of federal, state or local public employees, investment
company registered under the Investment Company Act of 1940, collective
investment trust organized by banks under Part Nine of the Rules of the
Comptroller of the Currency, closed end investment trust, chartered or licensed
life insurance company or property and casualty insurance company, banking and
other chartered or licensed lending institution, and investment advisor
registered under The Investment Advisors Act of 1940. In the discretion of the
NJCCC, a waiver of qualification may be
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granted to such institutional investors provided the securities are owned for
investment purposes only and the institutional investor certifies that it has no
intention of influencing or affecting the affairs of the issuer or its holding
companies.
A CSI license is issued for an initial period of two (2) years and is
thereafter renewable for four (4) year periods. There is no guarantee that,
following the issuance of an initial CSI license or any renewal thereof, the
Company will continue to be granted renewals of the license. Additionally, upon
application of the NJDGE, the NJCCC may at any time review any license issued by
it and determine to suspend, revoke or place conditions on such license.
While the NJCCC may deny the CSI application or revoke the license of the
Company should any officer, director, principal employee security holder or
other person who is required to but fails to be found qualified, the Company's
Articles of Incorporation authorize the Company to redeem at fair market value
Common Stock held by any person whose status as a shareholder may jeopardize the
Company's gaming licenses or approvals. In the discretion of the NJCCC, such
divestiture may be deemed sufficient action by the Company to obtain or retain
its CSI license. A change in ownership of a controlling interest of a CSI
licensee will void the license and the licensee will be required to apply for a
new license.
In addition to the required licensure from the NJCCC, the gaming equipment
manufactured, distributed or sold by the Company to New Jersey casinos is
subject to a technical examination by the NJDGE and approval by the NJCCC for,
at a minimum, quality, design, integrity, fairness, honesty and suitability. As
part of this approval process, the NJCCC may require that the manufacturer of
any component of the gaming equipment which the NJCCC, in its discretion,
determines is essential to the gaming operation of the device submit to
licensing. Such components would include the computer control circuitry which
causes or allows the device to operate as a gambling device. The failure or
refusal of such a manufacturer to submit to licensing or the denial of a license
by the NJCCC to such manufacturer would result in the inability of the Company
to distribute and market that gambling device to New Jersey casinos. While the
Company's OASIS II casino information management system products are presently
in use in a New Jersey casino pursuant to the transactional waivers granted by
the NJCCC to the Company, there can be no assurance that any modifications to
such casino information management system or other component parts thereof would
be approved by the NJCCC or that any other gaming devices subject to approval by
the NJCCC prior to use in New Jersey casinos would receive such approval.
NEVADA REGULATORY MATTERS
The manufacture, sale and distribution of gaming devices for use or play in
Nevada or for distribution outside of Nevada, the manufacture and distribution
of associated equipment for use in Nevada, and the operation of inter-casino
linked systems in Nevada are subject to: (i) The Nevada Gaming Control Act and
the regulations promulgated thereunder (collectively, the "Nevada Act"); and
(ii) various local ordinances and regulations. Such activities are subject to
the licensing and regulatory control of the Nevada Gaming Commission ("Nevada
Commission"), the Nevada State Gaming Control Board ("Nevada Board"), and
various local, city and county regulatory agencies (collectively referred to as
the "Nevada Gaming Authorities").
The Company is registered by the Nevada Commission as a publicly traded
corporation (a "Registered Corporation") and has also been licensed as a
manufacturer and distributor of gaming devices. The Company has also been found
suitable to own the stock of CDS Gaming (the "Nevada Subsidiary") which is
licensed as an operator of an inter-casino linked system. As a Registered
Corporation, the Company is required periodically to submit detailed financial
and operating reports to the Nevada Commission and furnish any other information
which the Nevada Commission may required. The Company and the Nevada Subsidiary
have obtained from the Nevada Gaming Authorities the various registrations,
findings or suitability, approvals, permits and licenses in order to engage in
manufacturing, distribution and inter-casino linked system activities in Nevada.
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All gaming devices that are manufactured, sold or distributed for use or
play in Nevada, or for distribution outside of Nevada, must be manufactured by
licensed manufacturers and distributed or sold by licensed distributors. All
gaming devices manufactured for use or play in Nevada must be approved by the
Nevada Commission before distribution or exposure for play. The approval process
for gaming devices includes rigorous testing by the Nevada Board, a field trial
and a determination as to whether the gaming device meets strict technical
standards that are set forth in the regulations of the Nevada Commission.
Associated equipment must be administratively approved by the Chairman of the
Nevada Board before it is distributed for use in Nevada.
The Nevada Gaming Authorities may investigate any individual who has a
material relationship to, or material involvement with, the Company or the
Nevada Subsidiary in order to determine whether such individual is suitable or
should be licensed as a business associate of a gaming licensee. No person or
legal entity may acquire control of the Company without the prior approval of
the Nevada Commission. Any beneficial holder of the Company's voting securities,
regardless of the number of shares owned, may be required to file an
application, be investigated, and have his suitability determined as a
beneficial holder of the Company's voting securities if the Nevada Commission
has reason to believes that such ownership would otherwise be inconsistent with
the declared policies of the State of Nevada. The applicant must pay all costs
of investigation incurred by the Nevada Gaming Authorities in conducting any
such investigation.
The Nevada Act requires any person who acquires beneficial ownership of more
than 5% of a Registered Corporation's voting securities to report the
acquisition to the Nevada Commission. The Nevada Act required that beneficial
owners of more than 10% of a Registered Corporation's voting securities apply to
the Nevada Commission for a finding of suitability within thirty days after the
Chairman of the Nevada Board mails the written notice requiring such filing.
Under certain circumstances, an "institutional investor," as defined in the
Nevada Act, which acquires more than 10%, but not more than 15%, of the
Registered Corporation's voting securities may apply to the Nevada Commission
for a waiver of such finding of suitability if such institutional investor holds
the voting securities for investment purposes only. An institutional investor
shall not be deemed to hold voting securities for investment purposes unless the
voting securities were acquired and are held in the ordinary course of business
as an institutional investor and not for the purpose of causing, directly or
indirectly, the election of a majority of the members of the board of directors
of the Registered Corporation, any change in the Registered Corporation's
corporate charter, bylaws, management, policies or operations of the Registered
Corporation, or any of its gaming affiliates, or any other action which the
Nevada Commission finds to be inconsistent with holding the Registered
Corporation's voting securities for investment purposes only. Activities which
are not deemed to be inconsistent with holding voting securities for investment
purposes only include: (i) voting on all matters voted on by stockholder; (ii)
making financial and other inquiries of management of the type normally made by
securities analysts for information purposes and not to cause a change in its
management, policies or operations; and (iii) such other activities as the
Nevada Commission may determine to be consistent with such investment intent. If
the beneficial holder of voting securities who must be found suitable is a
corporation, partnership or trust, it must submit detailed business and
financial information including a list of beneficial owners. The applicant is
required to pay all costs of investigation.
Any person who fails or refuses to apply for a finding of suitability or
license within thirty days after being ordered to do so by the Nevada Commission
or the Chairman of the Nevada Board, may be found unsuitable. The same
restrictions apply to a record owner if the record owner, after request, fails
to identify the beneficial owner. Any stockholder found unsuitable and who
holds, directly or indirectly, any beneficial ownership of the voting securities
of a Registered Corporation beyond such period of time as may be prescribed by
the Nevada Commission may be guilty of a criminal offense. The Company is
subject to disciplinary action if, after it receives notice that a person in
unsuitable to be a stockholder or to have any other relationship with the
Company or its subsidiaries, the Company (i) pays that person any dividend or
interest upon voting securities of the Company, (ii) allows that person to
exercise, directly or indirectly,
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any voting right conferred through securities held by that person, (iii) pays
remuneration in any form to that person for services rendered or otherwise, or
(iv) failed to pursue all lawful efforts to require such unsuitable person to
relinquish his voting securities for cash at fair market value.
The Nevada Commission may, in its discretion, require the holder of any debt
security of a Registered Corporation to file applications, be investigated and
be found suitable to own the debt security of a Registered Corporation. If the
Nevada Commission determines that a person is unsuitable to own such security,
then pursuant to the Nevada Act, the Registered Corporation can be sanctioned,
including the loss of its approvals, if without the prior approval of the Nevada
Commission, it: (i) pays to the unsuitable person any dividend interest, or any
distribution whatsoever; (ii) recognizes any voting right by such unsuitable
person in connection with such securities; (iii) pays the unsuitable person
remuneration in any form; or (iv) makes any payment to the unsuitable person by
way of principal, redemption, conversion, exchange, liquidation, or similar
transaction.
The Company and the Nevada Subsidiary are required to maintain a current
stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at
any time. If any securities are held in trust by an agent or by a nominee, the
record holder may be required to disclose the identity of the beneficial owner
to the Nevada Gaming Authorities. A failure to make such disclosure may be
grounds for finding the record holder unsuitable. The Company will also be
required to render maximum assistance in determining the identity of the
beneficial owner.
The Company may not make a public offering of its securities, such as the
Common Stock, without the prior approval of the Nevada Commission if the
securities or proceeds therefrom are intended to be used to construct, acquire
or finance gaming facilities in Nevada, or to retire or extend obligations
incurred for such purposes.
Changes in control of the Company through merger, consolidation, stock or
asset acquisitions, management or consulting agreements, or any act or conduct
by a person whereby he obtains control, may not occur without the prior approval
of the Nevada Commission. Entities seeking to acquire control of a Registered
Corporation must satisfy the Nevada Board and Nevada Commission in a variety of
stringent standards prior to assuming control of such Registered Corporation.
The Nevada Commission may also require controlling stockholders, officers,
directors and other persons having a material relationship or involvement with
the entity proposing to acquire control, to be investigated and licensed as part
of the approval process relating to the transaction.
The Nevada legislature has declared that some corporate acquisitions opposed
by management, repurchases of voting securities and corporate defense tactics
affecting Nevada gaming licensees, and Registered Corporations that are
affiliated with those operations, may be injurious to stable and productive
corporate gaming. The Nevada Commission has established a regulatory scheme to
ameliorate the potentially adverse effects of these business practices upon
Nevada's gaming industry and to further Nevada's policy to: (i) assure the
financial stability of corporate gaming operators and their affiliates; (ii)
preserve the beneficial aspects of conducting business in the corporate form;
and (iii) promote a neutral environmental for the orderly governance of
corporate affairs. Approvals are, in certain circumstances, required from the
Nevada Commission before the Company can make exceptional repurchases of voting
securities above the current market price thereof and before a corporate
acquisition opposed by management can be consummated. The Nevada Act also
requires prior approval of a plan of recapitalization proposed by the Company's
board of directors in response to a tender offer made directly to the Registered
Corporation's stockholders for the purposes of acquiring control of the
Registered Corporation.
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Any person who is licensed, required to be licensed, registered, required to
be registered, or is under common control with such persons (collectively,
"Licensees"), and who proposes to become involved in a gaming venture outside of
Nevada is required to deposit with the Nevada Board, and thereafter maintain, a
revolving fund in the amount of $10,000 to pay the expenses of investigation of
the Nevada Board of their participation in such foreign gaming. The revolving
fund is subject to increase or decrease in the discretion of the Nevada
Commission. Thereafter, licensees are required to comply with certain reporting
requirements imposed by the Nevada Act. Licensees are also subject to
disciplinary action by the Nevada Commission if it knowingly violates any laws
of the foreign jurisdiction pertaining of the foreign gaming operation, fails to
conduct the foreign gaming operation in accordance with the standards of honesty
and integrity required of Nevada gaming operations, engages in activities that
are harmful to the State of Nevada or its ability to collect gaming taxes and
fees, or employs a person in the foreign operation who has been denied a license
or finding of suitability in Nevada on the grounds of personal unsuitability.
The loss or restriction of the Company's gaming licenses in Nevada would
have a material adverse effect on its business and could require the Company to
cease its manufacturing, distribution and inter-casino linked system activities
in Nevada.
MISSISSIPPI REGULATORY MATTERS
The manufacture, sale and distribution of gaming devices and associated
equipment for use or play in Mississippi and the operation of inter-casino
linked systems in Mississippi are subject to the Mississippi Gaming Control Act
and the regulations promulgated thereunder (collectively, "Mississippi Act").
Although not identical, the Mississippi Act is similar to the Nevada Gaming
Control Act. Such activities are subject to the licensing and regulatory control
of the Mississippi Gaming Commission (the "Mississippi Commission") and the
Mississippi State Tax Commission (collectively referred to as the "Mississippi
Gaming Authorities").
The laws, regulations and supervisory procedures of the Mississippi Gaming
Authorities are based upon declarations of public policy which are concerned
with, among other things: (i) the prevention of unsavory or unsuitable persons
from having a direct or indirect involvement with gaming, or manufacturing or
distribution of gaming devices at any time or in any capacity; (ii) the
establishment and maintenance of responsible accounting practices and
procedures; (iii) the maintenance of effective controls over the financial
practices of licensees, including the establishment of minimum procedures for
internal fiscal affairs and the safeguarding of assets and revenues, providing
reliable record keeping and requiring the filing of periodic reports with the
Mississippi Gaming Authorities; (iv) the prevention of cheating and fraudulent
practices; (v) provide a source of state and local revenues through taxation and
licensing fees, and (vi) to ensure that gaming licensees, to the extent
practicable, employ Mississippi residents. Change in such laws, regulations and
procedures could have an adverse effect on the Company and the Company's
Mississippi operations.
The Company is registered by the Mississippi Commission as a publicly traded
corporation (a "Registered Corporation") and holding company of CDS Services
Company and CDS Gaming Company (separately, a "Mississippi Subsidiary" or
collectively, the "Mississippi Subsidiaries"). As a Registered Corporation, the
Company is required periodically to submit detailed financial and operating
reports to the Mississippi Commission and furnish any other information which
the Mississippi Commission may require. No person may become a stockholder of,
or receive any percentage of profits from, the Mississippi Subsidiaries without
first obtaining licenses and approvals from the Mississippi Gaming Authorities.
The Company and the Mississippi Subsidiaries have obtained from the Mississippi
Gaming Authorities the various registrations, approvals, permits and licenses in
order to engage in manufacturing, distribution and gaming activities as
presently conducted in Mississippi.
Manufacturers' and distributors' licenses and gaming licenses are not
transferable, are initially issued for a two-year period and must be renewed
periodically thereafter.
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All gaming devices that are manufactured, sold or distributed for use or
play in Mississippi must be manufactured by licensed manufacturers, and
distributed or sold by licensed distributors. All gaming devices manufactured
for use or play in Mississippi must be approved by the Mississippi Commission
before distribution or exposure for play. The approval process for gaming
devices includes rigorous testing by the Mississippi Commission, a field trial
and a determination as to whether the gaming device meets strict technical
standards that are set forth in the regulations of the Mississippi Commission.
Associated equipment must be administratively approved by the Executive Director
of the Mississippi Commission before it is distributed for use in Mississippi.
The Mississippi Commission may investigate any individual who has a material
relationship to, or material involvement with, the Company or the Mississippi
Subsidiaries in order to determine whether such individual is suitable or should
be licensed as a business associate of a gaming licensee. Officers, directors
and certain key employees of the Mississippi Subsidiaries are required to file
applications with the Mississippi Commission and may be required to be licensed
or found suitable by the Mississippi Commission. Officers, directors and key
employees of the Company who are actively and directly involved in gaming
activities of the Mississippi Subsidiaries may be required to be licensed or
found suitable by the Mississippi Commission. The Company believes that findings
of suitability with respect to such persons have been applied for or obtained,
although the Mississippi Commission in its discretion may require additional
persons to file applications for findings of suitability. The Mississippi
Commission may deny an application for licensing for any cause which they deem
reasonable. A finding of suitability is comparable to licensing, and both
require submission of detailed personal and financial information followed by a
thorough investigation. The applicant for licensing or a finding of suitability
must pay all the costs of the investigation. Changes in licensed positions must
be reported to the Mississippi Commission and in addition to its authority to
deny an application for a finding of suitability or licensure, the Mississippi
Commission has jurisdiction to disapprove a change in a corporate position.
If the Mississippi Commission were to find an officer, director or key
employee unsuitable for licensing or unsuitable to continue having a
relationship with the Company or the Mississippi Subsidiaries, the companies
involved would have to sever all relationships with such person. In addition,
the Mississippi Commission may require the Company or the Mississippi
Subsidiaries to terminate the employment of any person who refuses to file
appropriate applications or whom the authorities find unsuitable to act in such
capacity. Determinations of suitability or of questions pertaining to licensing
are not subject to judicial review in Mississippi.
The Mississippi Subsidiaries are required to submit detailed financial and
operating reports to the Mississippi Commission. Substantially all material
loans, leases, sales of securities and similar financing transactions by the
Mississippi Subsidiaries are required to be reported to or approved by the
Mississippi Commission.
If it were determined that the Mississippi Act was violated by the
Mississippi Subsidiaries, the licenses they hold could be limited, conditioned,
suspended or revoked, subject to compliance with certain statutory and
regulatory procedures. In addition, at the discretion of the Mississippi
Commission, the Mississippi Subsidiaries, the Company and the persons involved
could be subject to substantial fines for each separate violation of the
Mississippi Act. Limitation, conditioning or suspension of licenses held by the
Mississippi Subsidiaries could (and revocation of any license would) materially
adversely affect the Company's manufacturing, distribution and inter-casino
linked system operations.
Any beneficial holder of the Company's voting securities, regardless of the
number of shares owned, may be required to file an application, be investigated,
and have his suitability determined as a beneficial holder of the Company's
voting securities if the Mississippi Commission has reason to believe that such
ownership may be inconsistent with the declared policies of the State of
Mississippi. The applicant must reimburse all costs of investigation incurred by
the Mississippi Commission in conducting any such investigation.
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The Mississippi Act requires any person who acquires beneficial ownership of
more than 5% of a Registered Corporation's voting securities to report the
acquisition to the Mississippi Commission and such person may be required to be
found suitable. The Mississippi Act requires that beneficial owners of more than
10% of a Registered Corporation's voting securities apply to the Mississippi
Commission for a finding of suitability. The Mississippi Commission has
generally exercised its discretion to require a finding of suitability of any
beneficial owner of more than 5% of a Registered Corporation's common stock.
Under certain circumstances, an "institutional investor," as defined by
Mississippi Commission policy, which acquires more than 3%, but not more than
10%, of the Registered Corporation's voting securities may apply to the
Mississippi Commission for a waiver of such finding of suitability if such
institutional investor holds the voting securities for investment purposes only.
If the beneficial holder of voting securities who must be found suitable is a
corporation, partnership or trust, it must submit detailed business and
financial information including a list of beneficial owners. The applicant is
required to pay all costs and fees that the Mississippi Commission incurs in
conducting the investigation.
Any person who fails or refuses to apply for a finding of suitability or a
license within thirty (30) days after being ordered to do so by the Mississippi
Commission or the Executive Director may be found unsuitable. The same
restrictions apply to a record owner if the record owner, after request, fails
to identify the beneficial owner. Any stockholder found unsuitable and who
holds, directly or indirectly, any beneficial ownership of the common stock of
the Company beyond such period of time as may be prescribed by the Mississippi
Commission may be guilty of a criminal offense. The Company will be subject to
disciplinary action if, after it receives notice that a person is unsuitable to
be a stockholder or to have any other relationship with the Company or the
Mississippi Subsidiaries, the Company (i) pays the unsuitable person any
dividends or interest upon voting securities of the Company, (ii) recognizes the
exercise, directly or indirectly, of any voting rights conferred through
securities held by the unsuitable person, (iii) pays the unsuitable person any
remuneration in any form for services rendered or otherwise, except in certain
limited and specific circumstances or (iv) fails to pursue all lawful efforts to
require the unsuitable person to relinquish his voting securities, including, if
necessary, the immediate purchase of said voting securities for cash at fair
market value.
The Company may be required to disclose to the Mississippi Commission upon
request the identities of security holders, including the holders of any debt or
equity securities. In addition, the Mississippi Commission under the Mississippi
Act may, in its discretion, (i) require holders of debt securities of such
Registered Corporations to file applications, (ii) investigate such holders, and
(iii) require such holders to be found suitable to own such debt or equity
securities. The Mississippi Commission retains the discretion to require the
holders of debt or equity securities to be investigated and found suitable for
any reason, including but not limited to a default on a debt instrument, or
where the holder of the debt instrument or equity security exercises a material
influence over the gaming operations of the entity in question. Any holder of
debt or equity securities required to apply for a finding of suitability must
pay all investigative fees and costs of the Mississippi Commission in connection
with such an investigation.
The Mississippi Subsidiaries are required to maintain a current stock ledger
in their principal office in Mississippi and the Company must maintain a current
list of equity stockholders in the principal office of the Mississippi
subsidiaries which must reflect the record ownership of each outstanding share
of any class of equity security issued by the Company. The stock holder list may
thereafter be maintained by adding reports regarding the ownership of such
securities that it receives from the Company's transfer agent. The ledger and
stock holder lists must be available for inspection by the Mississippi
Commission at any time. If any securities are held in trust by an agent or by a
nominee, the record holder may be required to disclose the identity of the
beneficial owner to the Mississippi Commission. A failure to make such
disclosure may be grounds for finding the record holder unsuitable. The Company
will also be required to render maximum assistance to the Mississippi Commission
in determining the identity of the beneficial owner. The Mississippi Commission
has the power to require the stock certificates of the Company to bear a legend
indicating that the securities are subject to the Mississippi Act and the
regulations of the Mississippi
19
<PAGE>
Commission. The Company has received a waiver from this requirement from the
Mississippi Commission. The Mississippi Commission has the power to impose
additional restrictions on the holders of the Company's securities at any time.
Substantially all loans, leases, sales of securities and similar financing
transactions by a Mississippi Subsidiary must be reported to or approved by the
Mississippi Commission. A Mississippi Subsidiary may not make a public offering
of its securities, but may pledge or mortgage casino facilities, if it obtains
the prior approval of the Mississippi Commission. The Company may not make a
public offering of its securities without the approval of the Mississippi
Commission if the securities or proceeds therefrom are intended to be used to
construct, acquire or finance gaming facilities in Mississippi, or to retire or
extend obligations incurred for such purposes. The Company has received an
annual renewal of continuous approval of all public offerings from the
Commission and therefore is only required to obtain the Executive Director's
approval of an offering or securities. Such approval does not constitute a
finding, recommendation or approval by the Mississippi Commission or the
Executive Director as to the accuracy or adequacy of the prospectus or the
investment merits of the securities offered. Any representation to the contrary
is unlawful.
Changes in control of the Company through merger, consolidation, stock or
asset acquisitions, management or consulting agreements, certain
recapitalizations and stock repurchases by the Company, or any act or conduct by
a person whereby he obtains control, may not occur without the prior approval of
the Mississippi Commission. Entities seeking to acquire control of the Company
must satisfy the Mississippi Commission with respect to a variety of stringent
standards prior to assuming control of such company. The Mississippi Commission
may also require controlling stockholders, officers, directors and other persons
having a material relationship or involvement with the entity proposing to
acquire control, to be investigated and licensed as part of the approval process
relating to the transaction.
The Mississippi legislature has declared that some corporate acquisitions
opposed by management, repurchases of voting securities and corporate defense
tactics affecting Mississippi corporate gaming licensees, and Registered
Corporations that are affiliated with those operations, may be injurious to
stable and productive corporate gaming. The Mississippi Commission has
established a regulatory scheme to ameliorate the potentially adverse effects of
these business practices upon Mississippi's gaming industry and to further
Mississippi's policy to: (i) assure the financial stability of corporate gaming
licensees and their affiliates, (ii) preserve the beneficial aspects of
conducting business in the corporate form; and (iii) promote a neutral
environment for the orderly governance of corporate affairs. Approvals are, in
certain circumstances, required from the Mississippi Commission before the
Company can make exceptional repurchases of voting securities in excess of the
current market price thereof and before a corporate acquisition opposed by
management can be consummated. The Mississippi Act and the Mississippi
Commission gaming regulations also require prior approval of a plan of
recapitalization proposed by the Company's Board of directors in response to a
tender offer made directly to the Company's stockholders for the purposes of
acquiring control of the Company.
Neither the Company nor any subsidiary may engage in gaming activities in
Mississippi while also conducting gaming operations outside of Mississippi
without approval of the Mississippi Commission. The Mississippi Commission may
require determinations that, among other things, there are means for the
Mississippi Commission to have access to information concerning the out-of-state
gaming operations of the Company and its affiliates. The current policy of the
Mississippi Commission has been to grant a waiver from this approval
requirement. CDS Gaming Company has received a waiver from the approval
requirement of the Mississippi Commission to operate in Nevada. The Mississippi
Commission will need to approve or grant a waiver from the approval requirement
for the Company's or its subsidiaries' future gaming operations outside
Mississippi or Nevada prior to engaging in such future operations.
If it were determined that the Mississippi Act or a gaming regulation was
violated by the Mississippi Subsidiaries, the licenses they hold could be
limited, conditioned, suspended or revoked, subject to compliance with certain
statutory and regulatory procedures, which action, if taken, could materially
adversely affect the Company's manufacturing, distribution and inter-casino
linked system.
20
<PAGE>
Annual license fees are also payable to the State of Mississippi for gaming
licenses and manufacturers and distributor's licenses. The foregoing license
fees are allowed as a credit against the Company's Mississippi income tax
liability for the year paid.
FEDERAL REGULATION
The Federal Gambling Devices Act of 1962 (the "Johnson Act") makes it
unlawful, in general, for a person to manufacture, deliver, or receive gaming
machines, gaming machine type devices and components across state lines or to
operate gaming machines unless that person has first registered with the
Attorney General of the United States. The Company is required to register and
renew its registration annually. The Company has complied with such registration
requirements. In addition, various record keeping equipment identification
requirements are imposed by the Johnson Act. Violation of the Johnson Act may
result in seizure and forfeiture of the equipment, as well as other penalties.
NATIVE AMERICAN GAMING
Gaming on Native American lands, including the terms and conditions under
which gaming equipment can be sold or leased to Native American tribes, is or
may be subject to regulation under tribal ordinances, the terms of compacts
between the tribe and the host state, the Indian Gaming Regulatory Act of 1988
("IGRA"), which is administered by the National Indian Gaming Commission (the
"NIGC") and the Secretary of the U.S. Department of the Interior (the
"Secretary"), and also may be subject to the provisions of certain statutes
relating to contracts with Native American tribes, which are administered by the
Secretary. The regulations and guidelines under which the NIGC and the Secretary
will administer IGRA are incomplete and evolving. IGRA also is subject to
interpretation by the NIGC and the secretary, and may be subject to judicial and
legislative clarification or amendment.
IGRA prohibits substantially all forms of commercial gaming on Native
American lands, including gaming involving slot machines and gaming devices,
unless (i) the tribe on whose lands the gaming will take place has adopted an
ordinance, which has been approved by the NIGC, authorizing and regulating such
gaming, and (ii) the state in which the gaming will take place permits such
gaming by any person for any purpose. If the commercial gaming involves slot
machines and gaming devices, IGRA also requires that the tribe and the state
have entered into a written agreement (a "tribal-state compact") that
specifically authorizes such types of commercial gaming, and that has been
approved by the secretary, with notice of such approval published in the Federal
Register.
Tribal-state compacts vary from state to state. Many require that equipment
suppliers meet ongoing registration and licensing requirements of the state
and/or the tribe; some establish equipment standards that may limit or prohibit
the placement of progressive games on Indian lands; and some impose background
check requirements on the officers, directors, and shareholders of gaming
equipment suppliers.
In addition to federal and state governmental requirements pertaining to
gaming on Native American lands, Native American tribes are sovereign nations
with their own courts and governmental systems. Under IGRA, tribes are required
to regulate all commercial gaming under ordinances approved by the NIGC. Such
ordinances may impose standards and technical requirements on gaming hardware
and software, and may impose registration, licensing, and background check
requirements on gaming equipment suppliers and their officers, directors, and
shareholders.
Because of their sovereign status, Native American tribes possess sovereign
immunity from unconsented suit. The Company intends to seek waivers of such
immunity, where appropriate, from tribes with whom the Company does business,
but there can be no assurance that such waivers will be obtained. If they are
not, the extent of the Company's ability to enforce its agreements with Native
American tribes will be severely circumscribed.
21
<PAGE>
Under doctrines enunciated by the Supreme Court of the United States,
federal and state courts are obliged, as a matter of law, to defer to the
jurisdiction of tribal courts in litigation where tribal interests are
substantially involved and where tribal courts may have jurisdiction. In such
instances, if a tribal court hears the litigation, its determinations likely
will be entitled to great deference in any state or federal court which later
might be asked to hear the matter. These facts may affect the ability of the
Company to effectively enforce its agreements with Native American tribes.
In addition to the foregoing, two federal statutes may have applicability to
commercial gaming contracts with Native American tribes:
l. Title 25, Section 81, of the United States Code states that "no agreement
shall be made by any person with any tribe of Indians, or individual Indians
not citizens of the United States, for the payment or delivery of any money
or other thing of value...in consideration of services for said Indians
relative to their lands...unless such contract or agreement be executed and
approved" by the Secretary or his or her designee. Agreements for services
relative to Native American lands which fail to conform with the
requirements of this section will be void and unenforceable, and all money
or other things of value paid under such void agreements is subject to
judicial forfeiture in litigation, which can be brought by any person, in
the name of the United States of America. In the Company's opinion, its
sales contracts are not for services, and therefore Title 25, section 81, of
the United States Code does not apply to the Company's contracts. The
Company also believes that its sales of its OASIS II systems are not
"relative to Native American lands" because, although the Company's products
ultimately may be used on Native American lands, the products themselves are
not related to such lands, and give the Company no control over such lands.
To date, the Secretary has not asserted that agreements for the sale of
goods to Indian tribes require his approval under Title 25, Section 81,
United States Code.
2. Title 25, Sections 261-264, United States Code (the "Indian Trader Licensing
Act" or "ITLA") creates a licensing requirement, and states that "any person
other than an Indian of the full blood who shall attempt to reside in the
Indian country, or on any Indian reservation, as a trader, or to introduce
goods, or to trade therein, without such license, shall forfeit all
merchandise offered for sale to the Indians or found in his possession, and
shall moreover be liable to a Penalty of $500..." The applicability of ITLA
to the Company's sale of systems on Native American reservations are
unclear. The Company has not obtained a license under ITLA because the
Company believes that (i) ITLA does not apply to the sale of gaming
equipment, (ii) ITLA has been superseded by IGRA; and (iii) ITLA may have no
applicability to any transaction, since the Secretary has adopted no
regulatory mechanism to implement ITLA.
APPLICATION OF FUTURE OR ADDITIONAL REGULATORY REQUIREMENTS
In the future, the Company intends to seek the necessary registrations,
licenses, approvals and findings of suitability for the Company, its products
and its personnel in other jurisdictions throughout the world where significant
sales are anticipated to be made. However, there can be no assurance that such
registrations, licenses, approvals or findings of suitability will be obtained
and will not be revoked, suspended or conditioned or that the Company will be
able to obtain the necessary approvals for its future products as they are
developed in a timely manner, or at all. If a registration, license, approval or
finding of suitability is required by a regulatory authority and the Company
fails to seek or does not receive the necessary registration, license, approval
or finding of suitability, the Company may be prohibited from selling its
products for use in the respective jurisdiction or may be required to sell its
products through other licensed entities at a reduced profit to the Company.
22
<PAGE>
NEVADA LEGISLATION
Two of the Nevada general corporation provisions, the "Acquisition of
Controlling Interest" and the "Combination with Interested Stockholders"
statutes, may have the effect of delaying or making it more difficult to effect
a change in control of the Company.
Generally, the Acquisition of Controlling Interest statutes prohibit an
acquiror, under certain circumstances, from voting shares of a target
corporation's stock after crossing certain threshold ownership percentages,
unless the acquiror obtains the approval of the target corporation's
disinterested stockholders. There are three thresholds: one-fifth or more but
less than one-third, one-third or more but less than a majority, and a majority
or more, of the outstanding voting power. Once an acquiror crosses one of the
above thresholds, those shares which an acquiring person or a person acting in
association with an acquiring person acquire or offer to acquire in an
acquisition, and acquire within 90 days after becoming an acquiring person
become "control shares" and such control shares are deprived of the right to
vote until disinterested stockholders restore the right. The Acquisition of
Controlling Interest statutes also provide that in the event control shares are
accorded full voting rights and the acquiring person has acquired control shares
with a majority or more of all voting power, any stockholder of record, other
than an acquiring person, who did not vote in favor of authorizing voting rights
to the control shares is entitled to demand payment for the fair value of his or
her shares. The Board of Directors must notify the dissenting stockholders,
within 20 days after the vote of the stockholders authorizing voting rights for
the control shares, that they have the right to receive the fair value of their
shares in accordance with statutory procedures established generally for
dissenters' rights.
In summary and subject to certain circumstances where they do not apply, the
Combination with Interested Stockholders statutes prevent a "resident domestic
corporation" from entering into a "combination" with an "interested stockholder"
unless certain conditions are met. A "resident domestic corporation" (hereafter
the "corporation") means any Nevada corporation that has 200 or more
stockholders. A "combination" is broadly defined and includes, among other
things, any merger or consolidation with an "interested stockholder," or an
affiliate or associate of the "interested stockholder," or any sale, lease,
exchange, mortgage, pledge, transfer or other disposition, in one transaction or
a series of transactions with an "interested stockholder," or any affiliate or
associate of an "interested stockholder," of assets of the resident domestic
corporation, or any subsidiary of a resident domestic corporation: (a) having an
aggregate market value equal to 5% or more of the aggregate market value of all
the assets of the corporation, (b) having an aggregate market value equal to 5%
or more of the aggregate market value of all outstanding shares of the
corporation, or (e) representing 10% or more of the earning power or net income
of the corporation. "Interested stockholder" means the beneficial owner,
directly or indirectly, of 10% or more of the voting power of the corporation,
or an affiliate or associate of the corporation that, at any time within three
years immediately before the date in question was the beneficial owner, directly
or indirectly, of 10% or more of the voting power of the corporation.
Effective October 1, 1993, the corporation may not engage in a combination
with an interested stockholder after the expiration of three years after the
interested stockholder acquired his shares, unless the combination or purchase
of shares by the interested stockholder is approved by the corporation's board
of directors before the interested stockholder acquired his shares. If such
board of directors' approval is not obtained, the combination may be approved by
a majority of the disinterested stockholders no earlier than three years
following the date of the interested stockholder's acquisition of the shares. A
combination engaged in with an interested stockholder of the corporation more
than three years after the date that the stockholder acquired his shares may be
permissible if (a) the consideration to be received by all of the disinterested
holders of outstanding common shares of the corporation is at least equal to the
higher of (i) the highest price per share paid by the interested stockholder
within three years immediately preceding the date of the announcement of the
combination, or within three years immediately before, or in, the transaction in
which he became an interested stockholder, whichever is higher, plus interest
compounded annually, less dividends paid, but no more may be subtracted than the
amount of interest or (ii) the market
23
<PAGE>
value per common share on the date of the announcement of the combination or the
interested stockholder's acquiring shares, plus interest compounded annually,
less dividends paid, but no more may be subtracted than the amount of interest,
or (b) if, in the case of shares other than common shares, the consideration to
be received by all of the disinterested holders of outstanding shares other than
common shares of the corporation is at least equal to the highest of (i) the
highest price per share paid by the interested stockholder at a time when he was
the beneficial owner of 5% or more of the outstanding voting shares of the
corporation, for any shares of that class or series of shares acquired by him
within three years immediately preceding the date of the announcement of the
combination, or within three years immediately before, or in, the transaction in
which he became an interested stockholder, whichever is higher, plus interest
compounded annually, less dividends paid, but no more may be subtracted than the
amount of interest, (ii) the highest preferential amount to which the holders of
the class or series are entitled in the event of the voluntary liquidation of
the corporation or (iii) the market value per share of the class or series of
shares on the date of the announcement of the combination or the interested
stockholder's acquiring shares, plus interest compounded annually, less
dividends paid, but no more may be subtracted than the amount of interest.
ITEM 2. PROPERTIES
The Company owns a 140,000 square foot office, production, warehouse and
distribution facility in Las Vegas, Nevada where it houses its administrative,
sales, engineering, research and development and Nevada MSP system support
staff. The Company also leases an adjacent 45,000 square foot facility which
houses its sign business and occupies an approximate 6,000 square foot building
that formerly housed its electronic prepress services.
The Company purchased two additional buildings adjacent to its main
facility. Both facilities, one of which is approximately 9,100 square feet and
the other facility is approximately 8,450 square feet, are being offered for
sale.
The Company also leases regional sales and technical support offices in
Atlantic City, New Jersey; Plymouth, Minnesota; Sparks, Nevada and Gulfport,
Mississippi, which also houses the Mississippi MSP system monitoring, service
and support facility and owns a 6,000 square foot sales and technical support
office near Tunica, Mississippi. The Company also leases an approximately 4,500
square foot office in Colorado Springs, Colorado for the TurboPower Software
subsidiary.
ITEM 3. LEGAL PROCEEDINGS
In December, 1996, a class action complaint was filed in the United States
District Court, District of Nevada, by Gary A. Edwards against the Company and
certain present and former Company executives. Three additional purported
shareholder class actions were filed in 1997 in connection with the same drop in
stock price following the December 16, 1996 press release. The Company won a
motion to dismiss the First Amended Complaint filed by Edwards. The court,
however, granted Edwards leave to amend his Complaint. On July 13, 1998, Edwards
filed a Second Amended Complaint. Pending settlement, the parties stipulated to
stay the Company's response to this complaint. On May 29, 1997, SCHWARTZ V.
CASINO DATA SYSTEMS, was filed in the United States District Court for the
District of Nevada, alleging violations of Sections 10(b) and 20(a) of the 1934
ACT and SEC Rule 10b-5 and seeking economic recovery on behalf of the same
alleged class of investors. On December 16, 1997, GRANT V. CASINO DATA SYSTEMS,
was filed in the District Court of the State of Nevada alleging common law fraud
and seeking economic recovery on behalf of the same alleged class of investors.
On December 9, 1997, GIOVANNONI V. CASINO DATA SYSTEMS, was filed in the
Superior Court of the State of California in San Francisco alleging violation of
California Corporations Code Sections 25400 and 25500 and California Business
and Professions Code Sections 17200 and 17500. Management believes these claims
were without merit, and would have continued to vigorously defend against them.
However, due to the inherent risks and ongoing expense of maintaining
litigation, management determined it to be in the best interests of the Company
to settle the claims.
24
<PAGE>
Subject to court approval, the parties have agreed to a settlement of all four
related lawsuits, pursuant to which the Company paid $1 million in November
1998. The related charge is reflected as loss from shareholder suit in the
consolidated statement of operations.
A patron dispute was filed against the Company in connection with the
Company's Cool Millions dollars progressive slot machine at Splash Casino in
Tunica, Mississippi. The dispute was heard by the Mississippi Gaming Commission,
who decided that the patron had won only $5.00 rather than the jackpot of
$1,742,000 as alleged by the patron. The patron appealed the Commission's
decision to the Circuit Court of Tunica County. On January 16, 1998, the Court
issued an Order reversing the Commission's decision and ordered the Company to
pay the jackpot plus interest from April 8, 1995. The Company contends the
ruling is in error and has appealed the decision to the Mississippi Supreme
Court. As a result of the Circuit Court's Order, and with the consent of the
Mississippi Gaming authorities, the Company reduced the Cool Millions dollar
Mississippi jackpot by $1,742,000. The Company has accrued the entire jackpot
amount plus $360,000 of interest expense as of December 31, 1998 toward the
judgment, in the event the Company loses its appeal. CDS has filed its appeal
brief with the Mississippi Supreme Court. The matter is set for oral argument in
front of the Mississippi Supreme Court. While the outcome of the action
described above is not presently determinable, management does not expect the
outcome will have a material adverse effect on the Company's consolidated
financial position, results of operations or liquidity.
In August of 1997, Casino Technology Incorporated ("CTI"), filed a demand
for arbitration of certain issues arising out of a Cross-License Agreement
between CTI and the Company pursuant to which the Company marketed the Caribbean
Stud video poker game. CTI alleged that the Company failed to pay royalty fees
due under the agreement. The Company had accrued approximately $2,000,000 as of
December 31, 1997 with respect to potential obligations arising out of this
agreement. The Company contested this amount because it believed it had been
damaged as a result of certain actions and/or omissions of CTI and its
principal. The Company filed its Answer and Counterclaim on October 31, 1997,
alleging misrepresentation/ fraudulent inducement and breach of contract on
behalf of CTI. CTI filed a response to the Company's counterclaim. Due to the
inherent risks and ongoing expense of maintaining litigation, management
determined it to be in the best interest of the Company to settle this matter,
pursuant to which the Company agreed to pay CTI approximately $1,880,000. The
accrual has been adjusted as of December 31, 1998 to reflect the settlement
amount.
On May 19, 1998, Acres Gaming Corporation filed an action against the
Company, Mikohn Gaming Corporation, New York New York Hotel & Casino, LLC, and
Sunset Station Hotel & Casino, in the Federal Court for the State of Nevada,
alleging that the Company's ProTurbo Software module violated certain patent
rights of Acres Gaming. Acres Gaming also filed a Motion for Preliminary
Injunction, which was later withdrawn by Acres. The Company has answered the
lawsuit asserting defenses and counterclaims seeking a declaration of
invalidity, noninfringement and unenforceability of the patent asserted. The
Company believes this action is without merit and will continue to vigorously
defend itself. While the outcome of this lawsuit is not presently determinable,
management does not expect the outcome will have a material adverse effect on
the Company's consolidated financial position, results of operations or
liquidity.
On November 17, 1998, Acres filed a second lawsuit against the Company
alleging that the Company's ProTurbo Software module violates certain patent
rights of a second Acres patent. CDS has filed an answer and a counterclaim
seeking a declaration of invalidity, noninfringement and unenforceability of the
patent asserted. The Company has filed additional counterclaims for alleged
patent misuse, spoliation of evidence, antitrust violations and unfair
competition. The Company believes that this action is without merit and will
continue to vigorously defend itself. While the outcome of this lawsuit is not
presently determinable, management does not expect the outcome will have a
material adverse effect on the Company's consolidated financial position,
results of operations or liquidity.
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<PAGE>
The Company and its subsidiaries are also involved from time to time in
other various claims and legal actions arising in the ordinary course of
business including, but not limited to, administrative claims and legal actions
brought in state and federal courts by patrons of the Company's MSP games,
wherein the patron may allege the winning of jackpot awards or some multiple
thereof. Because of the size of the jackpots that a patron may play for, related
patron disputes often involve sizable claims. The loss of a sizable patron
dispute claim could have a material adverse effect on the Company. However,
management believes that the likelihood of success by those making such claims
is remote and that the ultimate outcome of these matters will not have a
material adverse effect on the Company's consolidated financial position,
results of operations or liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
No matter was submitted to a vote of the Company's security-holders during
the fourth quarter of the fiscal year ended December 31, 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK AND DIVIDEND POLICY
The Company's common stock has been traded on the NASDAQ National Market
under the symbol CSDS since April 5, 1993. The following table sets forth, for
the fiscal quarters indicated, the high and low sale prices per share for the
common stock, as reported on the NASDAQ National Market.
<TABLE>
<CAPTION>
HIGH LOW
--------- ---------
<S> <C> <C>
1997
First Quarter........................................................................... 8.75 4.69
Second Quarter.......................................................................... 5.38 3.44
Third Quarter........................................................................... 7.63 3.38
Fourth Quarter.......................................................................... 6.88 2.50
1998
First Quarter........................................................................... 4.56 2.94
Second Quarter.......................................................................... 4.19 2.63
Third Quarter........................................................................... 3.13 1.63
Fourth Quarter.......................................................................... 2.69 1.25
</TABLE>
On March 1, 1999, the last reported sale price of the common stock was
$2 1/4. As of February 28, 1998, the Company had approximately 311 holders of
record.
The Company has never declared or paid any cash dividends on its common
stock and the Board of Directors intends to retain all earnings, if any, for the
use in the Company's business for the foreseeable future. Any future
determination as to declaration and payment of dividends will be made at the
discretion of the Board of Directors.
ITEM 6. SELECTED FINANCIAL DATA (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
The selected data presented below should be read in conjunction with the
Financial Statements and notes thereto included elsewhere in this Form 10-K, and
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included elsewhere in this Form 10-K. The selected
data presented below under the captions "Consolidated Statement of Operations
Data" for the years ended December 31, 1998, 1997, 1996, 1995 and 1994 and
"Consolidated Balance Sheet Data" as of the end of each of the years in the
five-year period ended December 31, 1998 are derived from the
26
<PAGE>
consolidated financial statements of the Company and its subsidiaries, which
financial statements have been audited by KPMG LLP, independent certified public
accountants. The consolidated financial statements as of December 31, 1998 and
1997, and for each of the years in the three-year period ended December 31, 1998
and the report thereon, are included elsewhere in this Form 10-K. All share and
per share data have been adjusted for a 3 for 2 stock split effected on October
11, 1995 to shareholders of record on September 25, 1995 and an additional 3 for
2 stock split effected on February 27, 1996 to shareholders of record as of
February 20, 1996.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------------------
1998 1997 1996 1995 1994
--------- ----------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Consolidated Statement of Operations Data:
Total revenues........................................... 53,180 54,504 70,871 32,894 27,297
Total costs and expenses................................. 53,934 96,790 68,901 26,653 18,087
--------- ----------- --------- --------- ---------
(Loss) income from operations............................ (754) (42,286) 1,970 6,241 9,210
Total other income (expense)............................. 1,620 (499) 5,077 885 880
--------- ----------- --------- --------- ---------
Income (loss) before income taxes........................ 866 (42,785) 7,047 7,126 10,090
Income tax (benefit) expense............................. (1,647) (3,070) 2,232 2,394 3,555
--------- ----------- --------- --------- ---------
Net income (loss)...................................... $ 2,513 $ (39,715) $ 4,815 $ 4,732 $ 6,535
--------- ----------- --------- --------- ---------
--------- ----------- --------- --------- ---------
Basic net income (loss) per common share(1)............ $ 0.14 $ (2.20) $ 0.29 $ 0.35 $ 0.51
Diluted net income (loss) per common share(1).......... $ 0.14 $ (2.20) $ 0.28 $ 0.34 $ 0.50
Shares used in basic per share calculation(1).......... 18,066 18,043 16,892 13,572 12,860
Shares used in diluted per share calculations(1)....... 18,105 18,043 17,485 13,876 13,114
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------
1998 1997 1996 1995 1994
--------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents................................. $ 13,252 $ 27,873 $ 21,482 $ 13,157 $ 14,083
Working capital........................................... 39,967 41,514 58,226 23,136 29,950
Total assets.............................................. 99,010 96,956 125,422 60,307 43,296
Total liabilities......................................... 32,870 33,329 22,246 12,239 2,155
Total term debt, including current portion................ 211 2,454 4,482 4,304 588
Total shareholders' equity................................ 66,140 63,627 103,177 48,068 41,141
</TABLE>
- ------------------------
(1) The earnings per share numbers for years prior to 1997 were restated in 1997
to conform to the new requirements of Statement of Financial Accounting
Standard No. 128 "Earnings Per Share."
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of financial condition and results of
operations should be read in conjunction with the Consolidated Financial
Statements and Notes thereto included elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
REVENUES
Total revenues decreased to $53,180,000 for the twelve months ended December
31, 1998 from $54,504,000 for the same period in 1997, a decrease of $1,324,000
or 2%. This decrease is primarily attributable to a decrease in revenues from
recurring revenue products of $11,658,000 partially offset by increases in
systems and services sales of $3,833,000 and games sales of $8,233,000.
27
<PAGE>
System and services revenues increased to $23,147,000 for the twelve months
ended December 31, 1998 from $19,314,000 for the same period in the prior year,
an increase of $3,833,000 or 20%. The Company experienced an increase in OASIS
systems sales in 1998 compared to 1997 due primarily to the increase in the
demand for new systems. Among the key factors affecting new OASIS systems orders
are the rate of growth in the gaming industry and replacement of existing
systems. Although the Company believes that the market for its system is strong,
the continued existence and expansion of gaming markets is dependent upon
political, legal and other factors which are beyond the control of the Company.
Notable quarterly variations in revenue and income may occur since casino
management information systems constitute a primary source of revenue.
Revenues from game sales increased to $14,561,000 for the twelve months
ended December 31, 1998 from $6,328,000 for the same period in the prior year,
an increase of $8,233,000 or 130%. The increase in game sales is due primarily
to an expanded, and more popular, portfolio of game models available for sale.
Revenues from recurring revenue products decreased to $9,469,000 for the
twelve months ended December 31, 1998 from $21,127,000 for the same period in
the prior year, a decrease of $11,658,000 or 55%. This decrease in revenues is
primarily attributable to the termination of the Caribbean Stud Video Poker link
in October 1997, the termination of the Native American Cool Millions Dollar
link in February 1998 and the termination of both the Nevada and Mississippi
Cool Millions Dollar links in April 1998, partially offset by the increase in
revenue from the Nevada and Native American Xtreme links which were launched in
1998. The number of recurring revenue units was 556 at December 31, 1998 as
compared to 599 at December 31, 1997.
Revenues from signs decreased to $4,031,000 for the twelve months ended
December 31, 1998 from $4,244,000 for the same period in the prior year, a
decrease of $213,000 or 5%.
Revenues from software development tools increased to $1,847,000 for the
twelve months ended December 31, 1998 from $1,450,000 for the same period in the
prior year, an increase of $397,000 or 27%. This increase is primarily
attributable to new products released in 1998.
Revenues from graphics and imaging decreased to $125,000 for the twelve
months ended December 31, 1998 from $2,041,000 for the same period in 1997, a
decrease of $1,916,000 or 94%. This decrease is due to the restructuring of this
business unit resulting in the termination of external sales in the fourth
quarter of 1997. The $125,000 of revenue in 1998 represents fulfillment of
orders from 1997 and liquidation of inventory. The Company does not expect to
realize revenues from this business unit in future years.
GROSS MARGIN
Total cost of goods sold decreased from $39,212,000 for the twelve months
ended December 31, 1997, to $28,398,000 for the same period in 1998, a decrease
of $10,814,000 or 28%. Consolidated gross margin increased from $15,292,000 for
the twelve months ended December 31, 1997 to $24,782,000 for the same period in
1998. Consolidated gross margin as a percentage of revenues increased from 28%
for the twelve months ended December 31, 1997 to 47% for the same period in
1998. The increase in gross margin is primarily attributable to the increase in
the percentage of revenue derived from system and services sales which generally
produce higher margins.
Systems and services gross margin increased from $4,020,000 for the twelve
months ended December 31, 1997 to $15,995,000 for the same period in 1998, an
increase of $11,975,000 or 298%. This increase is primarily attributable to the
increase in software sales which generally have a higher gross margin than other
systems and service products and to the effect of the inventory write-down in
the fourth quarter of 1997 which did not occur in 1998.
Gross margin contributed from games increased to $1,261,000 for the twelve
months ended December 31, 1998 from $380,000 for the same period in the prior
year, an increase of $881,000 or 232%. This
28
<PAGE>
increase in primarily attributable to an increase in revenues and in the sale of
products with a higher gross margin in 1998 compared to those sold in same
period in 1997.
Gross margin contributed by recurring revenue products decreased to
$3,520,000 for the twelve months ended December 31, 1998 from $7,127,000 for the
same period in the prior year, a decrease of $3,607,000 or 51%. This decrease is
primarily attributable to the termination of several multi-site progressive
links during the twelve months ended December 31, 1998 and to decreased play in
general.
Gross margin from signs increased to $2,335,000 for the twelve months ended
December 31, 1998 from $1,539,000 for the same period in the prior year, an
increase of $796,000 or 52%. This increase is primarily attributable to an
increase in sales of higher margin meter products and to increased cost control
and production efficiencies.
Gross margin from the sale of software development tools increased to
$1,764,000 for the twelve months ended December 31, 1998 from $1,286,000, an
increase of $478,000 or 37%. This increase is primarily attributable to
increased revenues.
Gross margin from graphics and imaging products decreased to a loss of
$93,000 for the twelve months ended December 31, 1998 from gross margin of
$940,000 for the same period in the prior year, a decrease of $1,033,000 or
110%. This decrease is primarily attributable to the virtual elimination of
sales from this segment in the fourth quarter of 1997.
OPERATING EXPENSES
Operating expenses decreased from $57,578,000 for the twelve months ended
December 31, 1997, to $25,536,000 for the same period in 1998, a decrease of
$32,042,000 or 56%. Operating expenses decreased from $36,541,000, excluding the
restructuring and impairment charge, for the twelve months ended December 31,
1997, to $24,536,000, excluding the $1,000,000 charge for the loss from the
shareholders suit, for the same period in 1998, a decrease of $12,005,000 or
33%. Operating expenses decreased as a percentage of revenues from 106% for the
twelve months ended December 31, 1997, to 48% for the same period in 1998.
Selling, general and administrative expenses decreased from $23,306,000 for
the twelve months ended December 31, 1997, to $17,722,000 for the same period in
1998, a decrease of $5,584,000 or 24%. Selling, general and administrative
expenses as a percentage of revenues decreased from 43% for the twelve months
ended December 31, 1997, to 33% for the same period in 1998. These decreases are
due to overall cost reductions in virtually every component of selling, general
and administrative expenses during the twelve months ended December 31, 1998 as
compared to the same period in 1997 with the largest decreases coming from
decreases in headcount, travel expenses, outside consulting and advertising.
The provision for doubtful accounts decreased from $3,717,000 for the twelve
months ended December 31, 1997 to zero for the same period in 1998. The decrease
is attributable to better collections of accounts receivable in 1998 which
resulted in lower balances of accounts receivable considered to be
uncollectible.
Research and development expenses decreased from $3,959,000 for the twelve
months ended December 31, 1997, to $3,827,000 for the same period in 1998, a
decrease of $132,000 or 3%. The decrease is primarily attributable to a decrease
in lab and prototype expenses. Major expenditures during the twelve months ended
December 31, 1998 primarily included the development of additional video
interactive games and the completion of development of the Windows compatible
version of the OASIS II system. Research and development expenses as a
percentage of revenues remained stable at 7% for the twelve months ended
December 31, 1997, and 1998.
Restructuring and impairment charges of $21,037,000 for the twelve months
ended December 31, 1997 did not occur in 1998.
29
<PAGE>
Depreciation and amortization decreased from $5,559,000 for the twelve
months ended December 31, 1997, to $2,987,000 for the same period in 1998. The
decrease is primarily due to the decreased fixed asset balance as a result of
the restructuring and impairment charges in the fourth quarter of 1997.
OTHER INCOME (EXPENSE)
Other income is comprised of rental, interest, offset by interest expense,
and other forms of income that are not the result of core operations. Other
income increased from net expense of $499,000 for the twelve months ended
December 31, 1997, to income of $1,620,000 for the same period in 1998. The
increase is primarily due to the loss on disposal of assets of $1,888,000
recorded in 1997 with only $60,000 in 1998.
INCOME TAX BENEFIT
Income tax benefit decreased from a benefit of $3,070,000 for the twelve
months ended December 31, 1997 to a benefit of $1,647,000 for the same period in
1998. Although the Company recorded income before taxes for the year ended
December 31, 1998, it still received an income tax benefit of $1,647,000 for the
twelve months ended December 31, 1998. This benefit is primarily attributable to
a larger than expected refund from the 1997 federal income tax return of
$630,000, the income tax refund expected from the 1998 federal income tax return
of $580,000 and the favorable change in the Company's net deferred tax asset
resulting in a decrease in income tax expense of $516,000, partially offset by
state income taxes of $80,000.
NET INCOME (LOSS)
Net income (loss) increased from a loss of $39,715,000 for the twelve months
ended December 31, 1997, to income of $2,513,000 for the same period in 1998, an
increase of $42,228,000 or 106%. The increase in net income is a result of the
matters discussed above.
1997 RESTRUCTURING AND IMPAIRMENT
In the fourth quarter of 1997, the Company developed a restructuring plan
that encompassed nearly the entire organization and resulted in a charge to
income from operations of $14,998,000. Additionally, the Company recorded
impairment charges totaling $6,039,000. The components of the restructuring and
impairment charge which aggregated $21,037,000 are as follows:
SYSTEMS AND SERVICES
In the fourth quarter of 1997, the Company created and began implementing a
plan to accelerate the development of the Windows compatible version of its
OASIS II system. Substantially all engineering resources were reassigned to the
Windows project and several DOS based projects in development were abandoned.
These abandoned projects will not be completed and have no residual value.
Capitalized costs associated with the abandoned DOS projects totaled $1,200,000.
These costs were written off and were included as restructuring and impairment
charges in the accompanying consolidated statement of operations for the year
ended December 31, 1997.
COOL MILLIONS
In response to increasing competitive pressure, declining customer interest
and erosion in product performance, the Company decided to replace existing Cool
Millions operating assets. Operation of these links contributed $19,183,000 in
revenues and $7,480,000 of gross margin during the twelve months ended December
31, 1997. The gaming devices had book value of $5,000,000 before recognition of
any restructuring charge. Fair values of these gaming devices were determined
through discussion with third party used gaming equipment dealers. A charge of
$4,206,000 is included in restructuring and impairment
30
<PAGE>
charges in the consolidated statement of operations for the year ended December
31, 1997 to reduce the book value of the assets to their fair value. Throughout
1998, the Company liquidated these Cool Millions assets for prices at or
slightly greater than their book values. As of December 31, 1998, assets with
book value of approximately $19,000 remain in operation. Management expects to
liquidate these remaining Cool Millions assets in 1999 and does not expect to
recognize any loss on disposal.
The customized nature and aged design of the Cool Millions signage and
peripheral assets impair their fair value such that no material residual sales
value is expected. There is also no anticipated future operational use to the
Company. As a result, signage with a book value of $3,540,000 and peripheral
assets with a book value of $1,803,000 were written down to a fair value of
zero. These charges totaled $5,343,000 and are included in restructuring and
impairment charges in the accompanying consolidated statement of operations for
the year ended December 31, 1997.
CARIBBEAN STUD VIDEO POKER
The Company terminated the Caribbean Stud video poker link in October 31,
1997 due to the combination of lower than expected revenues and a fixed royalty
accruing to the licensor of the Caribbean Stud game technology (CTI). The
operation of this link contributed $1,944,000 in revenue and resulted in a
negative gross margin of $352,000 for the ten months ended October 31, 1997. The
gaming machines will be converted into other video poker programs and sold as
used equipment. The signage and other peripheral assets were customized for the
Caribbean Stud video poker link; therefore, they offer no future operating use
to the Company. The customized nature and aged designs of the signage and
peripheral assets impair their value such that no material residual value is
expected. As such, their carrying values were written down to zero through a
charge of $1,104,000 which is included in restructuring and impairment charges
in the accompanying consolidated statement of operations for the year ended
December 31, 1997.
CDS GRAPHICS & IMAGING
In the fourth quarter of 1997, the Company restructured the Graphics and
Imaging subsidiary to eliminate all sales operations. The subsidiary now
operates to satisfy internal demand only. Operation of this subsidiary
contributed $2,041,000 in revenue and resulted in a net loss of $43,000 for the
twelve months ended December 31, 1997 before restructuring and impairment
charges. The subsidiary's ongoing operations will be limited to production of
graphic art and flat glass for use only in CDS manufactured gaming devices. The
restructure included a reduction in personnel of 23 employees and calls for the
disposition of all equipment determined to be nonessential in producing to
satisfy internal demand. The restructuring resulted in the recognition of an
expected loss on disposal, the elimination of goodwill and the write-off of
finished goods inventory.
Assets representing nonessential equipment with book value of $1,526,000
have been written down to their estimated fair value of $525,000. The fair value
was determined through discussion with used equipment brokers. The balance of
associated goodwill of $671,000 is not considered recoverable and has been
written down to zero. Additionally, finished goods inventory of $490,000 have
been written down to zero. The finished goods inventory represents replacement
glass for previously processed customer orders which would normally be sold in
small lots as replacement supplies are needed. Without an external sales force,
and since customers generally prefer to purchase such replacement glass only
when needed, the Company does not expect to realize any material recoverable
value from the inventory. These write downs total $2,162,000 and are included in
restructure and impairment charges in the consolidated statement of operations
for the year ended December 31, 1997.
31
<PAGE>
TURBOPOWER SOFTWARE
In the fourth quarter of 1997, the Company committed to a plan to divest its
TurboPower Software subsidiary (TurboPower). Operation of this subsidiary
contributed $1,450,000 in revenues and resulted in a net loss of $595,000 for
the twelve months ended December 31, 1997. TurboPower was purchased in January
1995 to assist in development of general products and the Windows compatible
version of the OASIS system specifically. The Windows development effort by
TurboPower was ceased in the third quarter of 1997. In the fourth quarter of
1997, management concluded that TurboPower no longer fit within the Company's
overall market strategy and made the decision to actively pursue a buyer. Based
on an estimate of future cashflows and the estimated fair value of its assets,
the Company adjusted the book value of TurboPower's assets to down to their fair
value which resulted in a charge of $983,000. This charge is included in
restructuring and impairment charge in the consolidated statement of operations
for the year ended December 31, 1997. Due to TurboPower's stronger financial
performance in 1998 and to recent changes in various executive positions within
the Company, current management now believes that TurboPower will be an
important component of the Company's future success. Based on this, current
management discontinued its search for purchase candidates for TurboPower in the
fourth quarter of 1998 and reclassified its assets back to operating status.
IMPAIRMENT LOSS
In December 1997, the Company recorded a non-cash accounting charge related
to the impairment of certain long-lived assets as required by SFAS 121 in the
amount of $6,039,000. The impairment loss charge is comprised of three
components: (i) a charge of $4,401,000 related to capitalized amounts for
payments to a third party for game enhancements that were significantly behind
schedule, materially jeopardizing the possibility of recovering these costs,
(ii) a charge of $1,118,000 based on the cashflow projections for CDS Signs,
Inc. which indicated that the subsidiary will not generate enough cash to
recover the $1,118,000 in goodwill and (iii) a charge of $520,000 related to the
capitalized costs associated with a completed module application of the OASIS
system from which no revenues have yet been realized, expected future cash flows
are not sufficient to recover the associated capitalized costs and the net
realizable value is zero.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996
REVENUES
Total revenues decreased from $70,871,000 for the year ended December 31,
1996, to $54,504,000 for the same period in 1997, a decrease of $16,367,000 or
23%. The decrease in total revenues is primarily attributable to the $16,842,000
decrease in system sales for the twelve months ended December 31, 1997, as
compared to the same period in 1996.
Revenues from systems and services decreased to $19,314,000 for the twelve
months ended December 31, 1997 from $36,156,000 for the same period in the prior
year, a decrease of $16,842,000 or 47%. This decrease in revenues is primarily
attributable to the decrease in new casino openings and decrease in demand from
existing casinos for new systems.
Revenues from games increased to $6,328,000 for the twelve months ended
December 31, 1997 from $2,432,000 for the same period in the prior year, an
increase of $3,896,000 or 160%. This increase is primarily attributable to an
increased portfolio of game models available for sale.
Revenues from recurring revenue products decreased from $23,703,000 for the
year ended December 31, 1996, to $21,127,000 for the same period in 1997. This
decrease is primarily attributable to the decrease in the number of operational
units from 1,201 at December 31, 1996, to 599 at December 31, 1997 and overall
lower levels of play on the Company's progressive games.
32
<PAGE>
Revenues from signs increased to $4,244,000 for the twelve months ended
December 31, 1997 from $3,754,000 for the same period in the prior year, an
increase of $490,000 or 13%. This increase is primarily attributable to an
increase in demand for sign products.
Revenues from software development tools increased to $1,450,000 for the
twelve months ended December 31, 1997 from $1,341,000 for the same period in the
prior year, an increase of $109,000 or 8%.
Revenues from Graphics & Imaging decreased to $2,041,000 for the twelve
months ended December 31, 1997 from $3,485,000 for the same period in the prior
year, a decrease of $1,444,000 or 41%. This decrease is primarily attributable
to increased capacity utilized to fulfill internal demand.
GROSS MARGIN
Total costs of good sold increased from $38,620,000 for the twelve months
ended December 31, 1996, to $39,212,000 for the same period in 1997, an increase
of $592,000 or 2%. Gross margin decreased from $32,251,000 for the twelve months
ended December 31, 1996 to $15,292,000 for the same period in 1997. Gross margin
as a percentage of revenues decreased from 46% for the twelve months ended
December 31, 1996 to 28% for the same period in 1997. The decrease in gross
margin is primarily attributable to the decrease in total revenues, the decrease
in the percentage of total revenue derived from system and services sales and
the inventory write off of $3,500,000 recorded in the fourth quarter of 1997.
Gross margin contributed by systems and services decreased to $4,020,000 for
the twelve months ended December 31, 1997 from $17,383,000 for the same period
in the prior year, a decrease of $13,363,000 or 77%. This decrease in primarily
attributable to decreased revenues and the effects of the inventory write off
for the twelve months ended December 31, 1997 as compared to the same period in
1996.
Gross margin from games decreased to $380,000 for the twelve months ended
December 31, 1997 from $505,000 for the same period in the prior year, a
decrease of $125,000 or 25%. This decrease is primarily due to increases sales
of games with a lower gross margin for the twelve months ended December 31, 1997
as compared to the same period in the prior year.
Gross margin from recurring revenue products decreased to $7,127,000 for the
twelve months ended December 31, 1997 from $8,690,000 for the same period in the
prior year, a decrease of $1,563,000 or 18%. This decrease is primarily
attributable to decreased revenues for the twelve months ended December 31, 1997
compared to the same period in 1996.
Gross margin from signs decreased to $1,539,000 for the twelve months ended
December 31, 1997 from $2,107,000 for the same period in the prior year, a
decrease of $568,000 or 27%. This decrease is primarily attributable to sales
mix.
Gross margin from software development tools increased to $1,286,000 for the
twelve months ended December 31, 1997 from $1,094,000 for the same period in the
prior year, an increase of $192,000 or 18%. This increase is primarily
attributable to increased sales for the twelve months ended December 31, 1997
compared to the same period in 1996 combined with overall stronger gross profit
margin percentages during 1998.
Gross margin from graphics and imaging decreased to $940,000 for the twelve
months ended December 31, 1997 from $2,472,000 for the same period in the prior
year, a decrease of $1,532,000 or 62%. This decrease is primarily attributable
to lower revenues and an increase in smaller, lower gross margin jobs for the
twelve months ended December 31, 1997 as compared to the same period in 1996.
OPERATING EXPENSES
Operating expenses increased from $30,281,000 for the twelve months ended
December 31, 1996, to $57,578,000 for the same period in 1997, an increase of
$27,297,000 or 90%. Operating expenses increased
33
<PAGE>
as a percentage of revenues from 43% for the twelve months ended December 31,
1996, to 106% for the same period in 1998 due primarily to the restructuring and
impairment charge taken in the fourth quarter of 1997.
Selling, general and administrative expenses increased from $21,004,000 for
the year ended December 31, 1996, to $23,306,000 for the same period in 1997, an
increase of $2,302,000. The increase was primarily attributable to an increase
in the use of outside professional services. Selling general and administrative
expenses as a percentage of net revenues increased from 30% for the year ended
December 31, 1996, to 43% for the same period in 1997.
The provision for doubtful accounts increased from $2,793,000 for the year
ended December 31, 1996, to $3,717,000 for the same period in 1997. The increase
is primarily attributable to certain accounts receivable that have been
outstanding in excess of twelve months.
Research and development expenses increased from $3,114,000 for the year
ended December 31, 1996, to $3,959,000 for the same period in 1997, an increase
of $845,000. Research and development expenses as a percentage of revenue
increased from 4% for the year ended December 31, 1996, to 7% for the same
period in 1997.
Depreciation and amortization increased from $3,370,000 for the year ended
December 31, 1996, to $5,559,000 for the same period in 1997, an increase of
$2,189,000. This increase was primarily attributable to a full year of
depreciation on the increase in assets placed in service during 1996.
OTHER INCOME (EXPENSE)
Other income (expense) is primarily comprised of net earnings on
investments, interest expense, rental income and non-recurring payments that are
not the result of core operations. Other income (expense) decreased from
$5,077,000 for the year ended December 31, 1996, to expense of $499,000 for the
same period in 1997. The decrease is primarily due to a one-time settlement
payment from IGT due to a multi-faceted agreement which required a substantial
one-time cash payment to the Company during the third quarter of 1996. Interest
expense decreased from $481,000 for the year ended December 31, 1996 to $324,000
for the same period in 1997 due to decreased levels of long term liabilities.
Other income (expense) also includes a non-cash charge of $1,888,000 in 1997 for
the loss on disposal of certain assets, primarily computers and laboratory
equipment, which have been disposed of.
INCOME TAXES
Income tax expense decreased from $2,232,000 for the year ended December 31,
1996, to a benefit of $3,070,000 for the same period in 1997, a decrease of
$5,302,000. The decrease is primarily attributable to the decrease in income
from operations for the year ended December 31, 1997 as compared to the same
period in 1996.
NET (LOSS) INCOME
Net income decreased from $4,815,000 for the year ended December 31, 1996,
to a loss of $39,715,000 for the same period in 1997, a decrease of $44,530,000.
The decrease in net income is primarily attributable to the 1997 loss from
operations of $42,286,000 which included a charge of $21,037,000 for the
impairment of assets and restructuring.
LIQUIDITY AND CAPITAL RESOURCES
The Company to date has financed its operating and capital expenditures
through cash flows from its operations and cash from proceeds from its equity
offerings, investment activities and borrowings. The Company had cash and cash
equivalents of $13,252,000 at December 31, 1998, as compared to $27,873,000 at
December 31, 1997.
34
<PAGE>
Certain jurisdictions in which MSP systems operate require that the Company
maintain allocated funds or instruments to guarantee payment of jackpot prizes.
The amount of funds required is dependent upon several factors such as the type
and denomination of games and the local regulatory requirements. At December 31,
1998, the Company's accrued slot liability for its MSP systems aggregated
approximately $20,946,000, and there was no unaccrued slot liability (the
unaccrued slot liability is the amount of the initial primary jackpots that have
not been fully accrued). In connection with these slot liabilities and in
accordance with gaming requirements, the Company has restricted cash accounts
and short term investments aggregating approximately $9,070,000 as of December
31, 1998 to ensure availability of adequate funds to pay this liability. In
addition, the Company also has approximately $14,623,000 restricted as of
December 31, 1998, for the payment of jackpots already won. Although
statistically remote, a possibility exists that multiple jackpots may hit prior
to the time period over which game play has generated sufficient revenue to
accrue each jackpot reset amount. Such occurences could have a material adverse
impact on the Company's results of operations in the reporting period in which
the jackpots are hit.
As of December 31, 1998, the Company has equipment financing agreements for
an aggregate amount of $211,000. These equipment agreements are collateralized
by the related equipment and contain certain restrictive covenants, including
the requirement for a three year letter of credit securing payment in the amount
of 50% of the outstanding principal balance.
The Company's ratio of current assets to current liabilities is 3.8 to 1 at
December 31, 1998, while the noncurrent liabilities to equity ratio is .28 to 1.
The Company expects to continue to finance its operations and capital
expenditures through cash flow from operations; however, based on its financial
position, the Company believes it could obtain additional long-term financing in
1999 for anticipated growth that may result in working capital requirements that
exceed available cash and cash equivalents and cash to be provided by
operations. However, there can be no assurance that the Company will be able to
obtain additional sources of capital during 1999.
YEAR 2000
The year 2000 issue is the result of computer programs written using two
digits (rather than four) to define years. Computers or other equipment with
date-sensitive software may recognize "00" as 1900 rather than 2000. This could
result in system failures or miscalculations. If the Company, or its customers,
suppliers or other third parties fail to correct year 2000 issues, businesses
operations will be affected.
The Company is in the process of assessing the impact of the year 2000
issues on its internal processing systems and on the products produced and sold
by the Company. In September 1998, the Company formed an internal committee
comprised of management from every operational and functional department of the
Company. This committee is responsible for identifying and testing systems that
may be subject to year 2000 issues. This committee is also responsible for
formulating contingency plans if the Company experiences year 2000 issues.
The Company's internal information system, put into operation in the second
quarter of 1998, has been certified by the vendor as year 2000 compliant. The
operating system that this software uses has also been certified as year 2000
compliant by the third party manufacturer. The Company has tested certain
attributes of this system by processing test information in the year 2000
format. The results of those tests confirmed that the tested attributes are year
2000 compliant. Additional testing will be performed on the remaining
attributes. Management expects to be completed with this testing in September
1999. Based on the vendor assurances, and the results of the preliminary
testing, the Company believes that it will not experience any disruption in
daily operations with this system related to year 2000 issues; however, if such
disruption should occur, the Company believes that it could maintain ongoing
operations through manual record keeping procedures until computerized system
functionality is reestablished.
35
<PAGE>
The Company is also in the process of testing all desktop computers and
their associated software for year 2000 compliance. This testing is expected to
be completed by September 1999. The cost of upgrading noncompliant personal
computers and software is expected to be $225,000.
The Company operates its MSP systems using its own proprietary software
which utilizes a third party operating system which is not year 2000 compliant.
The Company is in the process of upgrading the operating system to a certified
year 2000 compliant version and will modify its proprietary software as
necessary. This upgrade will be completed in calendar year 1999 and the cost of
completing this upgrade is expected to be $10,000. With this upgrade, the
Company does not believe it will experience any disruption of MSP operations;
however, the MSP technology is dependent upon third party phone service as well
as computerized information systems and electricity at the various casino sites
where the MSP equipment is deployed. Disruption in any of these areas would
render MSP operations inoperable until service is reestablished.
The Company continues to review the impact of year 2000 issues concerning
the Company's production facility. No concerns have been identified. Therefore,
at this time, the Company believes that there will not be any material adverse
affect on its production capabilities resulting from year 2000 issues related to
the Company's production processes.
The Company also sells proprietary software to third parties. The Company
has year 2000 compliant versions of this software; however, the majority of the
Company's customer base uses a version of the software that includes certain
modules which are not year 2000 compliant. The Company has notified all of these
customers that they require an upgrade to become year 2000 compliant. The
Company plans to complete all such upgrades on customers covered by purchased
maintenance agreements in calendar year 1999 at an estimated cumulative cost of
approximately $100,000. The Company has also planned the resources necessary to
complete the upgrades for customers that are not under maintenance agreements;
however, performing these upgrades is contingent upon these customers
contracting for a fee with the Company to purchase an upgrade.
The Company has sent written questionnaires to its significant manufacturing
materials suppliers, banks, telecommunications suppliers, utility providers and
payroll service to assess their year 2000 readiness and the effect these third
parties could have on the Company. The Company plans to maintain communication
with significant suppliers and vendors with respect to this issue.
Based on current assessments and testing, the Company does not expect year
2000 issues to have a material adverse effect on the Company's financial
position, results of operations or cash flows. However, risk exists regarding
non-compliance of third parties with operational importance to the Company, such
as key suppliers and customers, utilities, telecommunication providers, or
financial institutions, which could result in lost production, sales, or
administrative difficulties on the part of the Company. Year 2000 issues, if
severe, could have a material effect on the Company. Pending completion of the
year 2000 assessment, the Company will finalize a contingency plan to address
possible risks of year 2000 noncompliance on the Company's financial position.
Though assessment and testing will be ongoing throughout 1999, the Company
expects to have its assessment, testing and contingency planning completed by
September 1999.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to the impact of interest rate changes and the
changes in the market values of its investments.
The Company's exposure to market rate risk for changes in interest rates
relates primarily to the Company's investment portfolio. The Company has not
used derivative financial instruments in its investment portfolio. The Company
invests its excess cash primarily in debt instruments of the U.S. Government and
its agencies and state and other municipal government agencies. By policy, the
Company
36
<PAGE>
limits the amount of credit exposure to any one issuer. The Company protects and
preserves its invested funds by limiting default, market and reinvestment risk.
Investments in fixed rate interest earning instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely impacted due to a rise in interest rates. The Company may suffer
losses in principal if forced to sell securities which have declined in market
value due to changes in interest rates.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL SCHEDULES
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Independent Auditors' Report.............................................................................. 38
Consolidated Balance Sheets as of December 31, 1998 and 1997.............................................. 39-40
Consolidated Statements of Operations for the years ended December 31, 1998,
1997 and 1996........................................................................................... 41
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998,
1997 and 1996........................................................................................... 42
Consolidated Statements of Cash Flows for the years ended December 31, 1998,
1997 and 1996........................................................................................... 43
Notes to Consolidated Financial Statements................................................................ 44-65
</TABLE>
FINANCIAL STATEMENT SCHEDULES AND SUPPLEMENTARY DATA
Schedule II, Valuation and Qualifying Accounts, for the years 1998, 1997 and
1996 have been submitted in Item 14. Part IV, hereof where the schedule is
listed. All other schedules have been omitted since they are either not
required, are not applicable, or the required information is shown in the
consolidated financial statements and related notes.
37
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Shareholders and Board of Directors
Casino Data Systems:
We have audited the accompanying consolidated balance sheets of Casino Data
Systems and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Casino Data
Systems and subsidiaries as of December 31, 1998 and 1997, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ KPMG LLP
Las Vegas, Nevada
February 23, 1999
38
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
(DOLLARS IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1998 1997
------------ ------------
<S> <C> <C>
Current assets:
Cash and cash equivalents............................... $ 5,141 $ 12,273
Restricted cash and cash equivalents.................... 8,111 15,600
Short-term investment securities, including restricted
amounts of $959 and $11 in 1998 and 1997,
respectively.......................................... 2,650 11
Accounts receivable, net of allowance for doubtful
accounts of $3,516 and $5,390 in 1998 and 1997,
respectively.......................................... 13,421 9,683
Due from related party.................................. -- 144
Current portion of notes receivable..................... 2,284 1,392
Income tax receivable................................... 642 4,000
Inventories............................................. 19,147 14,192
Deferred tax asset...................................... 1,176 360
Assets held for sale.................................... 922 880
Prepaid expenses and other current assets............... 244 1,244
------------ ------------
Total current assets.................................. 53,738 59,779
------------ ------------
Property and equipment, net............................... 19,828 17,736
Investment securities, including restricted amounts of
$14,623 and $6,601 in 1998 and 1997, respectively....... 14,623 8,080
Notes receivable, excluding current portion............... 1,137 1,627
Intangible assets, net.................................... 4,649 6,256
Software development costs, net of accumulated
amortization of $626 and $128 in 1998 and 1997,
respectively............................................ 3,804 1,954
Deposits.................................................. 391 384
Deferred tax asset........................................ 840 1,140
------------ ------------
Total non-current assets.............................. 45,272 37,177
------------ ------------
Total assets............................................ $ 99,010 $ 96,956
------------ ------------
------------ ------------
</TABLE>
See accompanying notes to consolidated financial statements
39
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
(DOLLARS AND SHARE DATA IN THOUSANDS)
LIABILITIES AND SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1998 1997
------------ ------------
<S> <C> <C>
Current liabilities:
Current portion long-term debt.................... $ 211 $ 2,187
Accounts payable.................................. 3,687 3,911
Accrued expenses and customer deposits............ 8,026 7,444
Accrued slot liability............................ 2,107 4,723
------------ ------------
Total current liabilities....................... 14,031 18,265
------------ ------------
Noncurrent liabilities:
Long term debt, excluding current portion......... -- 267
Accrued slot liability............................ 18,839 14,797
------------ ------------
Total noncurrent liabilities.................... 18,839 15,064
------------ ------------
Commitments and contingencies
Shareholders' equity:
Common stock, no par value. Authorized 100,000;
issued and outstanding 18,066 shares at December
31, 1998 and 1997, respectively................. 83,790 83,790
Accumulated deficit............................... (17,650) (20,163)
------------ ------------
Total shareholders' equity...................... 66,140 63,627
------------ ------------
Total liabilities and shareholders' equity...... $ 99,010 $ 96,956
------------ ------------
------------ ------------
</TABLE>
See accompanying notes to consolidated financial statements
40
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
--------- ---------- ---------
<S> <C> <C> <C>
Revenues:
Systems and services.......................................................... 23,147 19,314 36,156
Games......................................................................... 14,561 6,328 2,432
Recurring revenue products.................................................... 9,469 21,127 23,703
Signs......................................................................... 4,031 4,244 3,754
Software development tools.................................................... 1,847 1,450 1,341
Graphics and imaging.......................................................... 125 2,041 3,485
--------- ---------- ---------
Total revenues.............................................................. 53,180 54,504 70,871
Cost of goods sold............................................................ 28,398 39,212 38,620
--------- ---------- ---------
Gross margin.................................................................. 24,782 15,292 32,251
--------- ---------- ---------
Operating expenses:
Selling, general and administrative........................................... 17,722 23,306 21,004
Provision for doubtful accounts............................................... -- 3,717 2,793
Research and development...................................................... 3,827 3,959 3,114
Restructuring and impairment charge........................................... -- 21,037 --
Loss from shareholder suit.................................................... 1,000 -- --
Depreciation and amortization................................................. 2,987 5,559 3,370
--------- ---------- ---------
Total operating expenses.................................................... 25,536 57,578 30,281
--------- ---------- ---------
(Loss) income from operations............................................... (754) (42,286) 1,970
--------- ---------- ---------
Other income (expense):
Interest income and other income.............................................. 1,863 1,713 5,558
Loss on disposal of assets.................................................... (60) (1,888) --
Interest expense.............................................................. (183) (324) (481)
--------- ---------- ---------
Total other income (expense)................................................ 1,620 (499) 5,077
--------- ---------- ---------
Income (loss) before income taxes........................................... 866 (42,785) 7,047
Income tax (benefit) expense................................................ (1,647) (3,070) 2,232
--------- ---------- ---------
Net income (loss)......................................................... $ 2,513 $ (39,715) $ 4,815
--------- ---------- ---------
--------- ---------- ---------
Basic net income (loss) per common share...................................... $ 0.14 $ (2.20) $ 0.29
--------- ---------- ---------
--------- ---------- ---------
Diluted net income (loss) per common share.................................... $ 0.14 $ (2.20) $ 0.28
--------- ---------- ---------
--------- ---------- ---------
Basic weighted average shares outstanding..................................... 18,066 18,043 16,892
Diluted weighted average shares outstanding................................... 18,105 18,043 17,485
</TABLE>
See accompanying note to consolidated financial statements
41
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
RETAINED
COMMON STOCK EARNINGS
-------------------- (ACCUMULATED
SHARES AMOUNT DEFICIT) TOTAL
--------- --------- ------------ ---------
<S> <C> <C> <C> <C>
Balance at December 31, 1995...................................... 13,738 $ 33,331 $ 14,737 $ 48,068
Exercise of stock options......................................... 334 1,989 -- 1,989
Income tax benefits derived from exercise of stock options by
grantees......................................................... -- 1,347 -- 1,347
Issuance of common stock, pursuant to purchase of Telnaes
patent........................................................... 167 1,733 -- 1,733
Issuance of common stock.......................................... 3,795 45,225 -- 45,225
Net income........................................................ -- -- 4,815 4,815
--------- --------- ------------ ---------
Balance at December 31, 1996...................................... 18,034 83,625 19,552 103,177
Exercise of stock options......................................... 32 165 -- 165
Net loss.......................................................... -- -- (39,715) (39,715)
--------- --------- ------------ ---------
Balance at December 31, 1997...................................... 18,066 83,790 (20,163) 63,627
Net income........................................................ -- -- 2,513 2,513
--------- --------- ------------ ---------
Balance at December 31, 1998...................................... $ 18,066 $ 83,790 $ (17,650) $ 66,140
--------- --------- ------------ ---------
--------- --------- ------------ ---------
</TABLE>
See accompanying notes to consolidated financial statements
42
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
DOLLARS IN THOUSANDS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)........................................................... $ 2,513 $ (39,715) $ 4,815
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization............................................. 2,987 5,559 3,370
Amortization of intangible assets......................................... 1,347 337 --
Amortization of software development...................................... 133 -- --
Deferred income taxes..................................................... (516) 1,878 (2,872)
Restructuring and impairment charge....................................... -- 21,037 --
Loss on disposal of assets................................................ 60 1,887 --
Tax benefit of stock option exercises..................................... -- -- 1,347
Provision for accounts receivable......................................... -- 3,717 2,793
Changes in assets and liabilities:
Decrease (increase) in restricted cash and cash equivalents............. 7,489 (3,600) (6,000)
(Increase) decrease in accounts receivable, notes receivable and due
from related party.................................................... (3,996) 11,119 (18,675)
(Increase) decrease in income tax receivable............................ 3,358 (2,711) (1,289)
(Increase) decrease in inventories...................................... (4,955) 538 (9,905)
(Increase) decrease in other assets and deposits........................ 994 (42) 712
Increase (decrease) in accounts payable................................. (223) 971 428
Increase in accrued expenses, customer deposits and slot liability...... 2,008 12,141 9,475
---------- ---------- ----------
Net cash provided by (used in) operating activities................... 11,199 13,116 (15,801)
---------- ---------- ----------
Cash flows from investing activities:
Purchase of investment securities........................................... (9,182) (1,289) (6,802)
Increase in intangible assets............................................... (67) (392) (3,658)
Investment in software development.......................................... (2,348) (5,356) (2,316)
Acquisitions of property and equipment...................................... (4,491) (1,424) (16,489)
---------- ---------- ----------
Net cash used in investing activities................................... (16,088) (8,461) (29,265)
---------- ---------- ----------
Cash flows from financing activities:
Borrowings from operating line-of-credit.................................... -- -- 1,800
Principal payments on operating line-of-credit.............................. -- -- (1,800)
Repayment of notes payable.................................................. (2,243) (2,028) (1,900)
Proceeds from issuance of note payable...................................... -- -- 2,079
Net proceeds from issuance of common stock.................................. -- 165 47,214
---------- ---------- ----------
Net cash provided by (used in) financing activities..................... (2,243) (1,863) 47,393
---------- ---------- ----------
Net (decrease) increase in cash and cash equivalents.......................... (7,132) 2,792 2,327
Cash and cash equivalents at beginning of year................................ 12,273 9,481 7,154
---------- ---------- ----------
Cash and cash equivalents at end of year...................................... $ 5,141 $ 12,273 $ 9,481
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
See accompanying notes to consolidated financial statements
43
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) DESCRIPTION OF BUSINESS
Casino Data Systems, a Nevada corporation, was incorporated in June 1990.
Each of the following corporations are wholly owned subsidiaries of the
Company: CDS Services Company, CDS Graphics and Imaging Company, CDS
Signs, Inc., TurboPower Software Company and CDS Gaming Company. The
primary businesses of the Company are: (i) the development, licensing and
sale of casino management information systems; (ii) the operation of
multi-site link progressive (MSP) systems; (iii) the design and
manufacture of video interactive gaming machines, and (iv) the design and
manufacture of casino meters, signs and graphics. The Company also
creates software development tools for sale to outside software
professionals. The Company provides these products through operation of
five segments: systems and services, games, recurring revenue products,
signs and software development tools. Prior to 1998, the Company also
operated an additional graphics and imaging segment.
CDS Services Company was incorporated in June 1993 to provide direct
sales and service support to customers in certain gaming jurisdictions
where publicly-traded corporations must conduct business through a
subsidiary.
In January 1994, the Company acquired 100% of the outstanding common
stock of CDS Graphics and Imaging Company (formerly known as Paradise
Graphics, Inc.). CDS Graphics and Imaging Company produces flat-glass and
slot reel graphics for gaming machines.
CDS Gaming Company was incorporated in March 1994 to develop and operate
computerized multi-site linked progressive systems.
In January 1995, the Company purchased substantially all of the assets of
TurboPower Software, a Colorado sole proprietorship. TurboPower Software
designs, develops, and markets programming tools to professionals.
In September 1995, the Company purchased 100% of the outstanding voting
stock of CDS Signs, Inc. (formerly known as Fifty-Seven Corporation). CDS
Signs, Inc. designs and manufactures both indoor and outdoor signage,
primarily for casinos.
In April 1996, CDS Graphics and Imaging Company acquired 100% of the
outstanding common stock of Imageworks, Inc. for 27,000 restricted shares
of the Company's common stock. The acquisition was accounted for as a
pooling of interests, and accordingly, the consolidated financial
statements for periods prior to the combination have been restated to
include the results of operations of Imageworks, Inc.
(b) CONSOLIDATION POLICY AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Casino Data
Systems and all of its subsidiaries (collectively the "Company"). All
significant inter-company balances and transactions have been eliminated
in consolidation.
44
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
(c) REVENUE RECOGNITION
The Company sells Oasis systems, gaming machines, signs, meters, and
graphics products on normal credit terms (90 days or less) and
installment contracts (generally, less than one year). Revenue from Oasis
system sales is recorded in proportion to work completed using a method
that approximates the percentage-of-completion method, or if the contract
does not provide for the Company's installation of the system, the sale
is recorded upon shipment. Contracts for Oasis system sales generally
specify that the price is to be paid in three or four installments as
progress is made toward completion and that final payment under the
contract is not made until the expiration of an acceptance period during
which time the customer and applicable regulatory authorities may test
and approve the Company's Oasis system. Revenue on the sale of signs,
meters and graphics is generally recognized upon delivery. The sale of
gaming machines is recognized upon delivery for a standard sale. When
games are placed on a trial basis, revenue is recognized upon notice from
the customer of their decision to purchase the games. In the gaming
industry, it is traditionally required that game manufacturers allow
casinos to try new games on the floor for a period of time before
purchasing them. These games are considered to be games on trial and
remain on the Company's books until the decision to purchase is made.
Used games that return to the Company after unsuccessful trial periods
are generally sold at discounted prices that exceed cost. Recurring
revenues consist of revenues relating to the operations of the multi-site
linked progressive systems and a share of the coins wagered on machines
at customer locations. Revenue is recognized based on the Company's share
of the coins wagered.
(d) CASH AND CASH EQUIVALENTS
Cash equivalents consist of money market funds and short term debt
securities with original maturities of less than 90 days. These
investments are stated at cost, which approximates fair value. The
Company maintains restricted amounts to ensure availability of funds to
pay jackpot liabilities.
(e) SHORT-TERM INVESTMENT SECURITIES
Short-term investments consist principally of U.S. Government securities,
tax-exempt municipal obligations, and commercial paper. The Company
accounts for its short-term investments in accordance with the provisions
of Statement of Financial Accounting Standards No. 115, "Accounting for
Certain Investments in Debt and Equity Securities" ("SFAS 115"). Under
SFAS 115, the Company currently classifies its securities as
held-to-maturity. Held-to-maturity securities are those investments in
which the Company has the ability and intent to hold the security until
maturity. Held-to-maturity securities are recorded at amortized cost,
which approximates market value. All investments mature within a 12-month
period. Dividend and interest income are recognized in the period earned.
(f) FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosure About
Fair Value of Financial Instruments" (SFAS 107), requires all entities to
disclose the fair value of financial instruments, both assets and
liabilities recognized and not recognized on the balance sheet, for which
it is
45
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
practicable to estimate fair value. SFAS 107 defines fair value of a
financial instrument as the amount at which the instrument could be
exchanged in a current transaction between willing parties. At December
31, 1998 and 1997, the carrying value of all financial instruments (cash
and cash equivalents, accounts receivable, notes receivable, accounts
payable, accrued expenses and customer deposits and long-term debt)
approximates fair value due to the short term nature of the instruments
or interest rates are comparable with current rates. See Note (5) for
fair value regarding investments securities.
(g) INVENTORIES
Inventories are recorded at the lower of cost or market. Cost is
determined principally on the first-in first-out method. Inventories
consist of computer components and other hardware used in Oasis II casino
information management systems, gaming machines and components used in
gaming machines, meters, signs, and graphics production.
(h) ASSETS HELD FOR SALE
Assets held for sale are carried at the lower of net book or fair value
less costs to sell. Depreciation is discontinued when assets are
transferred to held for sale.
(i) PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation is calculated
using the straight-line method over the following estimated useful lives:
<TABLE>
<CAPTION>
<S> <C>
Building........................................................... 40 years
Furniture, fixtures and equipment.................................. 3 to 10 years
Gaming devices..................................................... 3 years
Service vehicles................................................... 5 to 7 years
</TABLE>
Leasehold improvements are amortized over the shorter of the lease term
(including expected renewals) or the useful life of the assets.
Normal repairs and maintenance are charged to expense when incurred.
Betterments and expenditures which materially extend the useful life of
the asset are capitalized.
(j) INTANGIBLE ASSETS
Intangible assets consist of costs associated with the establishment of
trademarks, purchase of a patent sublicense, gaming licenses in various
jurisdictions, the excess of the purchase price over the net assets of
acquired businesses (goodwill), and the unamortized balance of a
technology release agreement, all of which are capitalized and amortized
using the straight-line method over a period of 5 to 15 years.
(k) SOFTWARE DEVELOPMENT COSTS
The Company capitalizes software development costs paid to third parties
after technological feasibility is established and ceases when the
product is ready for release. Software development
46
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
costs are amortized over the greater of the ratio that current gross
revenues for a product bear to the total of current and anticipated
future gross revenues for that product or the straight line method over
the remaining estimated economic life of the product including the
current period reported on. Amortization of software development costs
begins when the products are ready for general release.
The Company capitalized $2,348,000 and $5,356,000 of software development
costs for the years ended December 31, 1998 and 1997, respectively and,
as discussed in Note (3), the Company wrote software development costs
down due to impairment in the fourth quarter of 1997. The Company
recorded software amortization $498,000 and $73,000 for the years ended
December 31, 1998 and 1997, respectively. Research and development costs
incurred to establish technological feasibility have been expensed when
incurred.
(l) RESEARCH AND DEVELOPMENT COSTS
Research and development costs related to designing, developing and
testing products are charged to expense as incurred. The Company accounts
for research and development tax credits as a reduction of the provision
for income taxes in the year in which the credits are realized.
(m) INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective
tax bases and operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences
are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income
in the period that includes the enactment date.
(n) SLOT LIABILITY
In connection with the operation of its MSP Systems, the Company is
liable for progressive jackpots, which are paid as an initial reset
amount (the base component) followed by an annuity (the progressive
component) paid out over 19 or 20 years after the winning combination is
hit. Base jackpots are charged to cost of goods sold ratably with the
level of play expected to precede payout based on a statistical analysis.
The progressive component increases at a rate based on the number of
coins played. The accrual of the liability and the associated charge to
cost of sales as the amount of the jackpot increases results in
recognition of liabilities and matching costs with revenues. The
possibility exists that the winning combination may be hit before the
Company has fully accrued the base component amount at which time any
unaccrued portion would be expensed.
47
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
(o) NET INCOME PER SHARE
Basic and diluted net income (loss) per share were computed in accordance
with SFAS No. 128 "Earnings Per Share." All share and per share data
presented in the consolidated financial statements and notes thereto have
been retroactively restated to give effect to stock splits.
(p) STOCK OPTION PLAN
Prior to January 1, 1996, the Company accounted for its stock option plan
in accordance with the provisions of Accounting Principles Board ("APB")
Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related
interpretations. As such, compensation expense would be recorded on the
date of grant only if the current market price of the underlying stock
exceeded the exercise price. On January 1, 1996, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 123, ACCOUNTING
FOR STOCK-BASED COMPENSATION, which permits entities to recognize as
expense over the vesting period the fair value of all stock-based awards
on the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of APB Opinion No. 25 and provide pro
forma net income and pro forma earnings per share disclosures for
employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in SFAS No. 123 had been applied. The
Company has elected to continue to apply the provisions of APB Opinion
No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.
(q) WARRANTY COSTS
The Company warrants its products for a period ranging from three months
to six months from the date of delivery, provided the products are used
under normal operating conditions. The Company accrues a reserve for
product warranty at the time of sale.
(r) IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
The Company reviews its long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison
of the carrying amount of an asset to future net cash flows (undiscounted
and without interest) expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the asset exceeds
the fair value of the asset. Assets to be disposed of are reported at the
lower of the carrying amount or fair value less costs to sell.
(s) USE OF ESTIMATES
Management has made a number of estimates and assumptions relating to the
reporting of assets and liabilities and the disclosure of contingent
assets and liabilities to prepare these consolidated financial statements
in conformity with generally accepted accounting principles. Actual
amounts could differ from these estimates.
48
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
(t) RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the
current year presentation.
(u) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities," which
establishes accounting and reporting standards for derivative instruments
and hedging activities. This statement shall be in effect for all fiscal
quarters of fiscal years beginning after June 15, 1999. SFAS 133 requires
that an entity recognize all derivatives as either assets or liabilities
in the statement of financial position and measure instruments at fair
value. SFAS 133 is not expected to have a material effect on the
Company's financial position or results of operations.
(2) MANAGEMENT'S PLAN
The Company continually reviews all components of its business for possible
improvement of future profitability and shareholder value through acquisition,
divestiture, reengineering or restructuring. In the fourth quarter of 1997, the
Company developed and initiated a restructuring plan designed to improve the
company's cost structure, streamline operations and divest the Company of
underperforming assets.
Implementation of the plan has resulted in certain asset impairment and
various expected losses to be incurred upon the disposal of assets to be
divested. These impairment losses and expected losses on disposal have been
recognized as required by the provisions of SFAS No. 121, ACCOUNTING FOR THE
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF.
Although the restructuring plan had a materially adverse affect on the 1997
results of operations, management believes that the plan was necessary in order
for the Company to achieve the greatest possible profitability in the future.
(3) 1997 RESTRUCTURING AND IMPAIRMENT
(Dollars in thousands)
In the fourth quarter of 1997, the Company developed a restructuring plan
that encompassed nearly the entire organization and resulted in a charge to
income from operations of $14,998. Additionally, the Company recorded impairment
charges totaling $6,039. The components of the restructuring and impairment
charge which aggregate $21,037 are as follow:
SYSTEMS AND SERVICES
In the fourth quarter of 1997, the Company created and began implementing a
plan to accelerate the development of the Windows compatible version of its
OASIS system. Substantially all engineering resources were reassigned to the
Windows project and several DOS based projects in development were abandoned.
These abandoned projects will not be completed and have no residual value.
Capitalized costs associated with the abandoned DOS projects totaled $1,200.
These costs were written off and were included as restructuring and impairment
charges in the accompanying consolidated statement of operations for the year
ended December 31, 1997.
49
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(3) 1997 RESTRUCTURING AND IMPAIRMENT (CONTINUED)
COOL MILLIONS
In response to increasing competitive pressure and erosion in product
performance, the Company decided to replace existing Cool Millions operating
assets. Operation of these links contributed $19,183 in revenues and $7,480 of
gross margin during the twelve months ended December 31, 1997. The gaming
devices had book value of $5,000 before recognition of any impairment charge.
Fair values of these gaming devices was determined through discussion with third
party used gaming equipment dealers. A charge of $4,206 is included in
restructuring and impairment charges in the consolidated statement of operations
for the year ended December 31, 1997 to reduce the book value of the assets to
their fair value. Throughout 1998, the Company liquidated these Cool Millions
assets for prices at or slightly greater than their book values. As of December
31, 1998, assets with book values of approximately $19,000 remain in operation.
Management expects to liquidate these remaining Cool Millions assets in 1999 and
does not expect to recognize any loss on disposal.
The customized nature and aged design of the Cool Millions signage and
peripheral assets impair their fair value such that no material residual sales
value is expected. There is also no anticipated future operational use to the
Company. As a result, signage with a book value of $3,540 and peripheral assets
with a book value of $1,803 were written down to a fair value of zero. These
charges totaled $5,343 and are included in restructuring and impairment charges
in the accompanying consolidated statement of operations for the year ended
December 31, 1997.
CARIBBEAN STUD VIDEO POKER
The Company terminated the Caribbean Stud video poker link in October 31,
1997 due to the combination of lower than expected revenues and a fixed royalty
accruing to the licensor of the Caribbean Stud game technology (CTI). The
operation of this link contributed $1,944 in revenue and resulted in a negative
gross margin of $352 for the ten months ended October 31, 1997. The gaming
machines will be converted into other video poker programs and sold as used
equipment. The signage and other peripheral assets were customized for the
Caribbean Stud video poker link; therefore, they offer no future operating use
to the Company. The customized nature and aged designs of the signage and
peripheral assets impair their value such that no material residual value is
expected. As such, their carrying values were written down to zero through a
charge of $1,104 which is included in restructuring and impairment charges in
the accompanying consolidated statement of operations for the year ended
December 31, 1997.
CDS GRAPHICS & IMAGING
In the fourth quarter of 1997, the Company restructured its Graphics and
Imaging subsidiary to eliminate all sales operations. The subsidiary now
operates to satisfy internal demand only. Operation of this subsidiary
contributed $2,041 in revenue and resulted in a net loss of $43 for the twelve
months ended December 31, 1997 before restructuring and impairment charges. The
subsidiary's ongoing operations will be limited to production of graphic art and
flat glass for use only in CDS manufactured gaming devices. The restructure
included a reduction in personnel of 23 employees and calls for the disposition
of all equipment determined to be nonessential in producing to satisfy internal
demand. The restructuring resulted in the recognition of an expected loss on
disposal, the elimination of goodwill and the write-off of finished goods
inventory.
50
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(3) 1997 RESTRUCTURING AND IMPAIRMENT (CONTINUED)
Assets representing nonessential equipment with book value of $1,526 have
been written down to their estimated fair value of $525. The fair value was
determined through discussion with used equipment brokers. The balance of
associated goodwill of $671 is not considered recoverable and has been written
down to zero. Additionally, finished goods inventory of $490 have been written
down to zero. The finished goods inventory represents replacement glass for
previously processed customer orders which would normally be sold in small lots
as replacement supplies are needed. Without an external sales force, and since
customers generally prefer to purchase such replacement glass only when needed,
the Company does not expect to realize any material recoverable value from the
inventory. These write downs total $2,162 and are included in restructure and
impairment charges in the consolidated statement of operations for the year
ended December 31, 1997.
TURBOPOWER SOFTWARE
In the fourth quarter of 1997, the Company committed to a plan to divest its
TurboPower Software subsidiary (TurboPower). Operation of this subsidiary
contributed $1,450 in revenues and resulted in a net loss of $595 for the twelve
months ended December 31, 1997. TurboPower was purchased in January 1995 to
assist in development of general products and the Windows compatible version of
the OASIS system specifically. The Windows development effort by TurboPower was
ceased in the third quarter of 1997. In the fourth quarter of 1997, management
concluded that TurboPower no longer fit within the Company's overall market
strategy and made the decision to actively pursue a buyer. Based on an estimate
of future cashflows and the estimated fair value of its assets, the Company
adjusted the book value of TurboPower's assets to down to their fair value which
resulted in a charge of $983. This charge is included in restructuring and
impairment charge in the consolidated statement of operations for the year ended
December 31, 1997. Due to TurboPower's stronger financial performance in 1998
and to recent changes various executive positions within the Company, management
now believes that TurboPower will be an important component of the Company's
future success. Based on this, current management discontinued its search for
purchase candidates for TurboPower in the fourth quarter of 1998 and
reclassified its assets back to operating status.
IMPAIRMENT LOSS
In December 1997, the Company recorded a non-cash accounting charge related
to the impairment of certain long-lived assets as required by SFAS 121 in the
amount of $6,039. The impairment loss charge is comprised of three components:
(i) a charge of $4,401 related to capitalized amounts for payments to a third
party for game enhancements that were significantly behind schedule, materially
jeopardizing the possibility of recovering these costs, (ii) a charge of $1,118
based on the cashflow projections for CDS Signs, Inc. which indicated that the
subsidiary will not generate enough cash to recover the $1,118 in goodwill and
(iii) a charge of $520 related to the capitalized costs associated with a
completed module application of the OASIS system from which no revenues have yet
been realized, expected future cash flows are not sufficient to recover the
associated capitalized costs and the net realizable value is zero. The SFAS 121
charge had no impact on the Company's 1997 cashflow or its ability to generate
cash flow in the future.
51
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(4) BUSINESS SEGMENTS
The Financial Accounting Standards Board issued Statement of Financial
Accounting Standard No. 131, "Disclosures About Segments of an Enterprise and
Related Information" for financial statements for periods ending after December
15, 1997. This statement supersedes Statement No. 14 and provides accounting
guidance for reporting information about operating segments in annual financial
statements and requires public business enterprises to report selected
information about operating segments in interim financial reports. Following is
the disclosure of the above items that management utilizes in measuring the
profit or loss of each of the Company's segments.
<TABLE>
<CAPTION>
FIXED ASSETS
--------------------
YEAR ENDED DECEMBER
31,
--------------------
1998 1997
--------- ---------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Systems and Services............................................. $ 1,932 $ 1,609
Games............................................................ 1,098 938
Recurring Revenue................................................ 3,462 1,172
Signs............................................................ 833 961
TurboPower....................................................... 273 --
Graphics & Imaging............................................... -- --
Corporate........................................................ 12,230 13,056
--------- ---------
Total.......................................................... $ 19,828 $ 17,736
--------- ---------
--------- ---------
</TABLE>
<TABLE>
<CAPTION>
REVENUES
-------------------------------
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Systems and Services........................... $ 23,147 $ 19,314 $ 36,156
Games.......................................... 14,561 6,328 2,432
Recurring Revenue.............................. 9,469 21,127 23,703
Signs.......................................... 4,031 4,244 3,754
TurboPower..................................... 1,847 1,450 1,341
Graphics & Imaging............................. 125 2,041 3,485
--------- --------- ---------
Total........................................ $ 53,180 $ 54,504 $ 70,871
--------- --------- ---------
--------- --------- ---------
</TABLE>
52
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(4) BUSINESS SEGMENTS (CONTINUED)
<TABLE>
<CAPTION>
DEPRECIATION AND AMORTIZATION
-------------------------------
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Systems and Services............................... $ 873 $ 618 $ 372
Games.............................................. 344 467 215
Recurring Revenue.................................. 988 2,817 1,529
Signs.............................................. 181 168 98
TurboPower......................................... -- 84 45
Graphics & Imaging................................. 79 370 306
Corporate.......................................... 522 1,035 805
--------- --------- ---------
Total............................................ $ 2,987 $ 5,559 $ 3,370
--------- --------- ---------
--------- --------- ---------
</TABLE>
TurboPower assets were held for sale during 1998; therefore, there is no
depreciation or amortization expense for that segment in 1998. Corporate
depreciation and amortization is related to assets utilized in the corporate
administration of the consolidated Company as a whole.
<TABLE>
<CAPTION>
INCOME (LOSS) FROM OPERATIONS
--------------------------------
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
--------- ---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Systems and Services............................ $ 5,122 $ (11,219) $ 199
Games........................................... (5,718) (9,683) (256)
Recurring Revenue............................... (610) (14,435) 2,024
Signs........................................... 523 (1,989) 493
TurboPower...................................... 148 (2,010) (894)
Graphics & Imaging.............................. (219) (2,950) 404
--------- ---------- ---------
Total......................................... $ (754) $ (42,286) $ 1,970
--------- ---------- ---------
--------- ---------- ---------
</TABLE>
Corporate expenses have been allocated to each segment based on management's
estimate of each segment's utilization of corporate resources. Included in
consolidated income (loss) from operations for the year ended December 31, 1997
is a restructuring and impairment charge of $21,037 as described in Note (3).
The above reported 1997 loss from operations for each segment includes amounts
related to this charge as follows: systems and services of $1,720; games of
$4,401; recurring revenue of $10,653; signs of $1,118; TurboPower of $983 and
graphics and imaging of $2,162.
53
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(5) INVESTMENT SECURITIES
The amortized cost, gross unrealized holding gains, and fair value for
held-to-maturity securities by major security type and class of security at
December 31, 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------------------------
AMORTIZED UNREALIZED FAIR
COST GAIN(LOSS) VALUE
----------- ----------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Securities to be held to maturity:
U.S. Government and agency securities................... $ 14,623 $ -- $ 14,623
State and municipal securities.......................... -- -- --
----------- ----------- ---------
$ 14,623 $ -- $ 14,623
----------- ----------- ---------
----------- ----------- ---------
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------------------------
AMORTIZED UNREALIZED FAIR
COST GAIN(LOSS) VALUE
----------- ----------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Securities to be held to maturity:
U.S. Government and agency securities................... $ 6,601 $ -- $ 6,601
State and municipal securities.......................... 1,479 (4) 1,475
----------- ----------- ---------
$ 8,080 $ (4) $ 8,076
----------- ----------- ---------
----------- ----------- ---------
</TABLE>
The approximate market values of securities held to maturity at December 31,
1998 by contractual maturity, are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
1998
------------
<S> <C>
Due in one year or less......................................................... $ 379
Due in one to five years........................................................ 4,531
Due in five to ten years........................................................ 4,550
Due in ten to fifteen years..................................................... 3,385
Due in fifteen to twenty years.................................................. 1,778
------------
$ 14,623
------------
------------
</TABLE>
(6) NOTES RECEIVABLE
The Company has granted customers extended payment terms under contracts of
sale evidenced by notes. These notes are generally for terms of one to two
years, with interest recognized at prevailing rates, and are secured by the
related equipment sold.
54
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(7) INVENTORIES
Inventories consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Raw Materials........................................................... $ 9,734 $ 8,508
Work in process......................................................... 711 269
Finished Goods.......................................................... 10,139 6,540
--------- ---------
20,584... 15,317
Less reserve for obsolescence........................................... (1,437) (1,125)
--------- ---------
$ 19,147 $ 14,192
--------- ---------
--------- ---------
</TABLE>
Finished goods inventory includes gaming machines on trial at various casino
sites of $2,182 and $2,708 at December 31, 1998 and December 31, 1997,
respectively.
(8) PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Furniture, fixtures and equipment....................................... $ 9,174 $ 7,361
Gaming devices.......................................................... 4,079 950
Service vehicles........................................................ 554 554
Leasehold improvements.................................................. 744 931
Buildings............................................................... 8,810 9,671
Land.................................................................... 1,816 1,816
--------- ---------
25,177 21,283
Less accumulated depreciation and amortization.......................... (5,349) (3,547)
--------- ---------
--------- ---------
$ 19,828 $ 17,736
--------- ---------
--------- ---------
</TABLE>
Gaming devices represent recurring revenue operational units deployed in
various casino sites. The net book value of collateral for equipment financing
agreements was $211 and $2,418 at December 31, 1998 and 1997, respectively.
55
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(9) INTANGIBLE ASSETS
Intangible assets consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Trademarks............................................................... $ 31 $ 31
Licensing costs.......................................................... 1,033 965
Technology release agreement............................................. 1,437 1,437
Telnaes patent........................................................... 4,943 4,943
--------- ---------
7,444 7,376
Less accumulated amortization............................................ (2,795) (1,120)
--------- ---------
$ 4,649 $ 6,256
--------- ---------
--------- ---------
</TABLE>
(10) LONG TERM OBLIGATIONS
Long term debt consists of equipment financing agreements at December 31,
1998 and 1997 as follow:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
9.0% note payable due in monthly installments of $43, including interest,
with final payment of $43 due February 28, 1999; secured by personal
property................................................................... $ 60 $ 567
9.15% note payable paid in full December 1998................................ -- 1,317
8.75% note payable due in monthly installments of $23, including interest,
with final payment due March 13, 1999; secured by personal property........ 46 329
11.12% note payable due in monthly installments of $9, including interest,
with final payment due December 31, 1999; secured by personal property..... 104 205
Other unsecured notes payable................................................ 1 36
--------- ---------
Total........................................................................ 211 2,454
Less current portion......................................................... 211 2,187
--------- ---------
Long term portion............................................................ $ -- $ 267
--------- ---------
--------- ---------
</TABLE>
56
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(10) LONG TERM OBLIGATIONS (CONTINUED)
Future minimum payments under equipment financing agreements are as follow:
<TABLE>
<CAPTION>
PAYMENTS
-----------
<S> <C>
Year ending December 31:
1999............................................................................. $ 219
Less interest...................................................................... (8)
-----
Present value of future minimum payments......................................... 211
-----
-----
</TABLE>
The Company has financed certain equipment under agreements which are
collateralized by the related equipment and contain certain restrictive
covenants, including the requirement for a three-year letter of credit securing
payment in the amount of 50% of the current principal balance.
(11) SHAREHOLDERS' EQUITY
(a) GENERAL
Pursuant to the purchase of the Telnaes patent sublicense on February 19,
1996, the Company issued 121,847 shares of restricted stock valued at
$10.83 per share. On April 22, 1996, the Company issued an additional
4,615 shares of restricted stock valued at $10.83 per share. On August 6,
1996, the Company issued a final installment 40,500 shares of restricted
stock valued at approximately $8.97 per share.
Pursuant to the Imageworks, Inc. agreement, on July 15, 1996, the Company
issued 27,000 shares of restricted stock in exchange for 100% of the
outstanding common stock of Imageworks, Inc.
In March 1996, the Company issued 3,795,000 shares of common stock in a
Secondary Public Offering at $12.75 per share.
(b) STOCK SPLITS
On January 31, 1996, the Company's Board of Directors authorized a
three-for-two stock split, effected in the form of a stock dividend to be
distributed on February 27, 1996, to shareholders of record on February
20, 1996.
All share and per share data presented have been retroactively restated
to give effect to this stock split.
(c) EMPLOYEE STOCK PURCHASE PLAN
On March 16, 1998, the Board of Directors of the Company adopted the 1998
Employee Stock Purchase Plan (the "1998 Purchase Plan"), which was
approved by the Company's stockholders in July 1998. Under the terms of
the 1998 Purchase Plan, employees may acquire shares of the Company's
stock at a 15 percent discount from their fair market value. In addition,
the 1998 Purchase Plan provides a mechanism whereby employees may pay for
their share purchases with periodic deductions from their payroll. The
1998 Purchase Plan authorizes the issuance of up to
57
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(11) SHAREHOLDERS' EQUITY (CONTINUED)
500,000 shares of common stock to eligible participants. No shares have
been issued under this plan.
(d) STOCK OPTION AND COMPENSATION PLAN
In January 1993, the Company adopted the 1993 Stock Option and
Compensation Plan (the Plan), pursuant to which options and other awards
to acquire an aggregate of 1,012,500 shares of Common Stock may be
granted. The number of shares issuable under the Plan was increased to an
aggregate 1,350,000 shares in June 1994, 2,025,000 shares in July 1996
and 2,775,000 in July 1998. In 1994, the Company adopted the 1994
Nonemployee Director Stock Option Plan pursuant to which 225,000 shares
are issuable.
The following table provides additional information regarding stock
options:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
EXERCISE
OPTIONS PRICE
---------- -----------
<S> <C> <C>
Outstanding at December 31, 1995............................. 1,199,420 $ 6.14
Granted...................................................... 793,474 15.79
Exercised.................................................... (334,195) 5.55
Canceled..................................................... (339,049) 11.10
---------- -----------
Outstanding at December 31, 1996............................. 1,319,650 11.50
Granted...................................................... 460,675 4.60
Exercised.................................................... (32,250) 5.21
Canceled..................................................... (385,585) 10.46
---------- -----------
Outstanding at December 31, 1997............................. 1,362,490 4.75
---------- -----------
Granted...................................................... 1,167,520 2.50
Exercised.................................................... -- --
Canceled..................................................... (954,375) 5.28
---------- -----------
Outstanding at December 31, 1998............................. 1,575,635 $ 3.37
---------- -----------
---------- -----------
Exercisable at December 31, 1998............................. 474,772 $ 5.29
---------- -----------
---------- -----------
</TABLE>
58
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(11) SHAREHOLDERS' EQUITY (CONTINUED)
The per share weighted average fair value of stock options granted during
1998, 1997 and 1996 was $1.31, $2.50 and $2.12, respectively, on the date
of grant using the Black Scholes option-pricing model with the following
weighted average assumptions for 1998, 1997 and 1996: expected dividend
yield of 0% for all three years; risk free interest rate of 5.25%, 5.75%
and 6.50%, respectively; and expected lives varying from one month to
three years. The following table summarizes information about stock
options outstanding at December 31, 1998:
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
RANGE OF EXERCISE REMAINING WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE
PRICE NUMBER OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- --------------------- ------------------- ---------------- ----------------- ----------- -----------------
<S> <C> <C> <C> <C> <C>
$0 - 1.81 521,300 4.68 years $ 1.76 -- $ --
1.82 - 3.00 247,720 4.25 years 2.96 44,718 3.00
3.01 - 4.94 501,875 3.50 years 3.37 149,395 3.51
4.95 - 6.75 264,990 2.53 years 5.17 240,909 5.17
6.76 - 16.00 39,750 2.18 years 15.22 39,750 15.22
---------- -----------
$1.81 to $16.00 1,575,635 3.81 years $ 3.37 474,772 $ 5.29
---------- -----------
---------- -----------
</TABLE>
The Company applies APB Opinion No. 25 in accounting for its Plan and no
compensation cost has been recognized for its stock options in the
financial statements. Had the Company determined compensation cost based
on the fair value at the grant date for its stock options under SFAS No.
123, the Company's net income (loss) and earnings per share would have
been reduced to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1998 1997 1996
--------- ---------- ---------
<S> <C> <C> <C>
Net income (loss):
As reported.................................................. $ 2,513 $ (39,715) $ 4,815
Pro forma.................................................... $ 1,836 $ (40,865) $ 3,700
Basic net income (loss) per common share:
As reported.................................................. $ 0.14 $ (2.20) $ 0.29
Pro forma.................................................... $ 0.10 $ (2.26) $ 0.22
Diluted net income (loss) per common share:
As reported.................................................. $ 0.14 $ (2.20) $ 0.28
Pro forma.................................................... $ 0.10 $ (2.26) $ 0.21
</TABLE>
59
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(11) SHAREHOLDERS' EQUITY (CONTINUED)
(e) NET INCOME (LOSS) PER COMMON SHARE
The following is an analysis of the components of the shares used to
compute net income (loss) per common share:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------------------
1998 1997 1996
------------ -------------- -------------
<S> <C> <C> <C>
Numerator for basic and diluted earnings per share--income
available to common stockholders........................ $ 2,513,000 $ (39,715,000) $ 4,815,000
Denominator:
Denominator for basic earnings per share--weighted average
shares.................................................. 18,066,000 18,043,000 16,892,000
Effect of dilutive securities--Stock options.............. 39,000 -- 593,000
------------ -------------- -------------
Denominator for diluted earnings per share-adjusted
weighted average shares and assumed conversions......... 18,105,000 18,043,000 17,485,000
------------ -------------- -------------
------------ -------------- -------------
Basic earnings per share.................................. $ 0.14 $ (2.20) $ 0.29
Diluted earnings per share................................ $ 0.14 $ (2.20) $ 0.28
</TABLE>
In 1997, assumed conversion of employee stock options would have been
anti-dilutive and were immaterial and, accordingly, were not considered
in the calculation of diluted earnings per share.
(12) INCOME TAXES
(Dollars in thousands)
Income tax (benefit) expense attributable to income from continuing
operations consists of:
<TABLE>
<CAPTION>
CURRENT DEFERRED TOTAL
--------- --------- ---------
<S> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1998:
U.S. Federal................................................ $ (1,211) $ (516) $ (1,727)
State....................................................... 80 -- 80
--------- --------- ---------
$ (1,131) $ (516) $ (1,647)
--------- --------- ---------
--------- --------- ---------
YEAR ENDED DECEMBER 31, 1997:
U.S. Federal................................................ $ (5,253) $ 1,878 $ (3,375)
State....................................................... 305 -- 305
--------- --------- ---------
$ (4,948) $ 1,878 $ (3,070)
--------- --------- ---------
--------- --------- ---------
YEAR ENDED DECEMBER 31, 1996:
U.S. Federal................................................ $ 4,869 $ (2,872) $ 1,997
State....................................................... 235 -- 235
--------- --------- ---------
$ 5,104 $ (2,872) $ 2,232
--------- --------- ---------
--------- --------- ---------
</TABLE>
60
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(12) INCOME TAXES (CONTINUED)
The effective income tax rate differs from the U.S. federal statutory rate
of 35% for the years ended December 31, 1998, 1997 and 1996, respectively, as
follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- ---------- ---------
<S> <C> <C> <C>
Computed "expected" income tax expense (benefit).............. $ 294 $ (14,975) $ 2,466
Tax exempt interest income.................................... (28) (116) (366)
State taxes, net of federal income tax benefit................ 53 107 152
Tax credits................................................... (1,604) -- --
Tax rate difference in carry back years....................... (307) 1,036 --
Change in valuation allowance................................. -- 10,006 --
Other, net.................................................... (55) 872 (20)
--------- ---------- ---------
$ (1,647) $ (3,070) $ 2,232
--------- ---------- ---------
--------- ---------- ---------
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and liabilities at December 31, 1998 and
1997 are as follows:
<TABLE>
<CAPTION>
CHANGE IN
1998 DEFERRED TAXES 1997
---------- -------------- ----------
<S> <C> <C> <C>
Deferred tax assets:
Accrued jackpot liability........................... $ 7,344 $ 512 $ 6,832
Accrued expenses.................................... 398 167 231
Allowance for doubtful accounts..................... 388 (200) 588
Intangible assets................................... 4,130 (479) 4,609
Inventory........................................... 485 (1,215) 1,700
Tax credits......................................... 1,603 1,603 --
NOL carryforward.................................... 1,858 1,858 --
---------- ------- ----------
16,206 2,246 13,960
Valuation allowance................................... (10,006) -- (10,006)
---------- ------- ----------
Net deferred tax assets........................... 6,200 2,246 3,954
---------- ------- ----------
Deferred tax liabilities:
Depreciation of property and equipment.............. 4,142 1,897 2,245
Deferred rent and prepaid expenses.................. 42 (167) 209
---------- ------- ----------
Total gross deferred tax liabilities.............. 4,184 1,730 2,454
---------- ------- ----------
Net deferred tax asset............................ $ 2,016 $ 516 $ 1,500
---------- ------- ----------
---------- ------- ----------
</TABLE>
Management has considered certain tax planning strategies as permitted by
SFAS No. 109.
A valuation allowance in the amount of $10,005,781 was established as of
December 31, 1997. Realization of the recorded deferred tax asset is dependent
upon generating sufficient taxable income in the future to offset future tax
deductions. Although realization is not assured, management believes it is more
likely than not that the net deferred tax asset will be realized. The amount of
the net deferred tax
61
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(12) INCOME TAXES (CONTINUED)
asset considered realizable could be reduced in the near term if estimates of
future taxable income are reduced.
(13) RELATED PARTY TRANSACTIONS
(Dollars in thousands)
A shareholder and former director of the Company and the spouse
(collectively the "Principals") of the Chairman of the Company are majority
shareholders in Kiland Distributing Corporation ("KDC"), a former distributor of
the Company's products. Prior to the third quarter of 1997, the Company utilized
KDC for substantially all sales in the mid-west region of the United States.
During the nine months ended September 30, 1997, the Company made sales to KDC
of approximately $169. The sales, recorded net of distributor discounts,
represent less than 1% of the Company's revenues for the nine months ended
September 30, 1997.
In September 1997, the Company and KDC reached an agreement regarding the
settlement of accounts receivable of $3,059 for approximately $2,400. The
settlement included the transfer of substantially all of KDC's assets to the
Company which included cash, accounts receivable and fixed assets. The
settlement also included forgiveness of certain accounts payable from the
Company to KDC and the execution of a $144 unsecured promissory note from the
Principals to the Company which was paid in full in March 1998. Concurrent with
the settlement, the Company terminated its business relationship with KDC.
(14) OPERATING LEASES
(Dollars in thousands)
The Company has several non-cancelable operating leases, primarily for
office and warehouse space, that expire over the next five years. Rent expense
under operating leases was $836, $951 and $863 for the years ended December 31,
1998, 1997 and 1996, respectively.
Future minimum lease payments under non-cancelable building operating leases
(with initial or remaining lease terms in excess of one year) as of December 31,
1998 are as follow:
<TABLE>
<CAPTION>
PAYMENTS
-----------
<S> <C>
Year ending December 31:
1999........................................................................... $ 664
2000........................................................................... 465
2001........................................................................... 66
2002........................................................................... 4
-----------
Total minimum lease payments................................................... $ 1,199
-----------
-----------
</TABLE>
(15) EMPLOYEE BENEFIT PLAN
Effective January 1, 1996, the Company adopted a 401(k) Plan (Plan)
qualified under Section 401 of the Internal Revenue Code of 1986. Eligible
employees of the Company who have satisfied the Plan's eligibility requirements
may participate in the Plan. Eligible employees may elect to contribute up to
15%
62
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(15) EMPLOYEE BENEFIT PLAN (CONTINUED)
of their compensation up to a maximum $9,500 in 1998. The Company may elect to
make profit sharing contributions to the Plan. The Company did not elect to make
a contribution to the Plan during 1998, 1997 or 1996.
(16) SALES TO PRINCIPAL CUSTOMERS
Sales to principal customers as a percentage of total revenues for the years
ended December 31, 1998, 1997, and 1996, are as follow:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Circus Circus Enterprises.......................................... 5% 1% 5%
Grand Casinos...................................................... 5 7 13
Mirage............................................................. 3 2 6
Showboat........................................................... 5 8 --
Stations Casinos................................................... 4 16 6
Other.............................................................. 78 66 70
--------- --------- ---------
100% 100% 100%
--------- --------- ---------
--------- --------- ---------
</TABLE>
(17) COMMITMENTS AND CONTINGENCIES
In December, 1996, a class action complaint was filed in the United States
District Court, District of Nevada, by Gary A. Edwards against the Company and
certain present and former Company executives. Three additional purported
shareholder class actions were filed in 1997 in connection with the same drop in
stock price following the December 16, 1996 press release. The Company won a
motion to dismiss the First Amended Complaint filed by Edwards. The court,
however, granted Edwards leave to amend his Complaint. On July 13, 1998, Edwards
filed a Second Amended Complaint. Pending settlement, the parties stipulated to
stay the Company's response to this complaint. On May 29, 1997, SCHWARTZ V.
CASINO DATA SYSTEMS, was filed in the United States District Court for the
District of Nevada, alleging violations of Sections 10(b) and 20(a) of the 1934
ACT and SEC Rule 10b-5 and seeking economic recovery on behalf of the same
alleged class of investors. On December 16, 1997, GRANT V. CASINO DATA SYSTEMS,
was filed in the District Court of the State of Nevada alleging common law fraud
and seeking economic recovery on behalf of the same alleged class of investors.
On December 9, 1997, GIOVANNONI V. CASINO DATA SYSTEMS, was filed in the
Superior Court of the State of California in San Francisco alleging violation of
California Corporations Code Sections 25400 and 25500 and California Business
and Professions Code Sections 17200 and 17500. Management believes these claims
were without merit, and would have continued to vigorously defend against them.
However, due to the inherent risks and ongoing expense of maintaining
litigation, management determined it to be in the best interests of the Company
to settle the claims. Subject to court approval, the parties have agreed to a
settlement of all four related lawsuits, pursuant to which the Company paid $1
million in November 1998. The related charge is reflected as loss from
shareholder suit in the consolidated statement of operations.
A patron dispute was filed against the Company in connection with the
Company's Cool Millions dollars progressive slot machine at Splash Casino in
Tunica, Mississippi. The dispute was heard by the Mississippi Gaming Commission,
who decided that the patron had won only $5.00 rather than the jackpot
63
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(17) COMMITMENTS AND CONTINGENCIES (CONTINUED)
of $1,742,000 as alleged by the patron. The patron appealed the Commission's
decision to the Circuit Court of Tunica County. On January 16, 1998, the Court
issued an Order reversing the Commission's decision and ordered the Company to
pay the jackpot plus interest from April 8, 1995. The Company contends the
ruling is in error and has appealed the decision to the Mississippi Supreme
Court. As a result of the Circuit Court's Order, and with the consent of the
Mississippi Gaming authorities, the Company reduced the Cool Millions dollar
Mississippi jackpot by $1,742,000. The Company has accrued the entire jackpot
amount plus $360,000 of interest expense as of December 31, 1998 toward the
judgment in the event the Company loses its appeal. CDS has filed its appeal
brief with the Mississippi Supreme Court. The matter is set for oral argument in
front of the Mississippi Supreme Court. While the outcome of the action
described above is not presently determinable, management does not expect the
outcome will have a material adverse effect on the Company's consolidated
financial position, results of operations or liquidity.
In August of 1997, Casino Technology Incorporated ("CTI"), filed a demand
for arbitration of certain issues arising out of a Cross-License Agreement
between CTI and the Company pursuant to which the Company marketed the Caribbean
Stud video poker game. CTI alleged that the Company failed to pay royalty fees
due under the agreement. The Company had accrued approximately $2,000,000 as of
December 31, 1997 with respect to potential obligations arising out of this
agreement. The Company contested this amount because it believed it had been
damaged as a result of certain actions and/or omissions of CTI and its
principal. The Company filed its Answer and Counterclaim on October 31, 1997,
alleging misrepresentation/fraudulent inducement and breach of contract on
behalf of CTI. CTI filed a response to the Company's counterclaim. Due to the
inherent risks and ongoing expense of maintaining litigation, management
determined it to be in the best interest of the Company to settle this matter,
pursuant to which the Company agreed to pay CTI approximately $1,880,000. The
accrual has been adjusted as of December 31, 1998 to reflect the settlement
amount.
On May 19, 1998, Acres Gaming Corporation filed an action against the
Company, Mikohn Gaming Corporation, New York New York Hotel & Casino, LLC, and
Sunset Station Hotel & Casino, in the Federal Court for the State of Nevada,
alleging that the Company's ProTurbo Software module violated certain patent
rights of Acres Gaming. Acres Gaming also filed a Motion for Preliminary
Injunction, which was later withdrawn by Acres. The Company has answered the
lawsuit asserting defenses and counterclaims seeking a declaration of
invalidity, noninfringement and unenforceability of the patent asserted. The
Company believes this action is without merit and will continue to vigorously
defend itself. While the outcome of this lawsuit is not presently determinable,
management does not expect that the outcome will have a material adverse effect
on the Company's consolidated financial position, results of operations or
liquidity.
On November 17, 1998, Acres filed a second lawsuit against the Company
alleging that the Company's
ProTurbo Software module violates certain patent rights of a second Acres
patent. CDS has filed an answer and a counterclaim seeking a declaration of
invalidity, noninfringement and unenforceability of the patent asserted. The
Company has filed additional counterclaims for alleged patent misuse, spoliation
of evidence, antitrust violations and unfair competition. The Company believes
that this action is without merit and will continue to vigorously defend itself.
While the outcome of this lawsuit is not presently determinable, management does
not expect the outcome will have a material adverse effect on the Company's
consolidated financial position, results of operations or liquidity.
64
<PAGE>
CASINO DATA SYSTEMS AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998 AND 1997
(17) COMMITMENTS AND CONTINGENCIES (CONTINUED)
The Company and its subsidiaries are also involved from time to time in
other various claims and legal actions arising in the ordinary course of
business including, but not limited to, administrative claims and legal actions
brought in state and federal courts by patrons of the Company's MSP games,
wherein the patron may allege the winning of jackpot awards or some multiple
thereof. Because of the size of the jackpots that a patron may play for, related
patron disputes often involve sizable claims. The loss of a sizable patron
dispute claim could have a material adverse effect on the Company. However,
management believes that the likelihood of success by those making such claims
is remote and that the ultimate outcome of these matters will not have a
material adverse effect on the Company's consolidated financial position,
results of operations or liquidity.
(18) SUPPLEMENTAL FINANCIAL INFORMATION
(Dollars in thousands)
CASH FLOW INFORMATION
Payments for interest expense for the years ended December 31, 1998, 1997
and 1996 were approximately $183, $324 and $481, respectively.
Payments for income taxes for the years ended December 31, 1998, 1997 and
1996 were approximately $0, $0 and $5,039 respectively.
65
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There has been no Form 8-K filed within 24 months prior to the date of the
most recent financial statements reporting a change of accountants or reporting
disagreements on any matter of accounting principle, practice, financial
statement disclosure or auditing scope or procedure.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information beginning immediately following the caption "Election of
Directors" to, but not including, the caption "Executive Compensation" in the
Company's Proxy Statement, to be filed with the Securities and Exchange
Commission within 120 days of the close of the Company's year ended December 31,
1998 and forwarded to stockholders prior to the Company's 1999 Annual Meeting of
Stockholders (the "1998 Proxy Statement"), is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information in the 1998 Proxy Statement beginning immediately following
the caption "Executive Compensation" to, but not including, the caption
"Compensation Committee Interlocks and Insider Participation" is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information in the 1998 Proxy Statement beginning immediately following
the caption "Voting Securities and Principal Holders Thereof" to, but not
including, the caption "Election of Directors" is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information in the 1998 Proxy Statement under the caption "Certain
Transactions" is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) These documents are listed in the Index to Consolidated Financial
Statements and Supplementary Data in Item 8 of this report.
(a)(2) Schedules
See Schedule attached.
66
<PAGE>
FORM 10-K
CASINO DATA SYSTEMS AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING OF COST AND CHARGED TO END OF THE
THE YEAR EXPENSES OTHER ACCOUNTS DEDUCTIONS YEAR
------------ ------------ --------------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1998:
Allowance for doubtful accounts.............. $ 5,390,000 $ 0 $ 0 $ 1,874,000 $ 3,516,000
Allowance for obsolescence................... $ 1,125,000 $ 966,000 $ 0 $ 654,000 $ 1,437,000
Year ended December 31, 1997:
Allowance for doubtful accounts.............. $ 2,867,747 $ 3,717,389 $ 0 $ 1,195,136 $ 5,390,000
Allowance for obsolescence................... $ 0 $ 1,125,000 $ 0 $ 0 $ 1,125,000
Year ended December 31, 1996:
Allowance for doubtful accounts.............. $ 88,848 $ 2,792,747 $ 0 $ 13,848 $ 2,867,747
Allowance for obsolescence................... $ 0 $ 0 $ 0 $ 0 $ 0
</TABLE>
67
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Casino Data Systems has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized:
<TABLE>
<S> <C> <C>
CASINO DATA SYSTEMS
/s/ STEVEN A. WEISS
-------------------------------------
By: Steven A. Weiss,
Chief Executive Officer and Chairman of
the Board
(Principal Executive Officer)
Date: March 26, 1999
</TABLE>
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
<TABLE>
<S> <C> <C>
/s/ STEVEN A. WEISS
- ------------------------------
Steven A. Weiss, Chief Date: March 26, 1999
Executive Officer and
Chairman of the Board
(Principal Executive
Officer)
/s/ LEE LEMAS
- ------------------------------
Lee Lemas, Chief Financial Date: March 26, 1999
Officer and Chief
Operating Officer
(Principal Financial and
Accounting Officer)
/s/ PHIL BRYAN
- ------------------------------
Phil Bryan, Director Date: March 26, 1999
/s/ HOWARD YENKE
- ------------------------------
Howard Yenke, Director Date: March 26, 1999
/s/ THOMAS GARDNER
- ------------------------------
Thomas Gardner, Director Date: March 26, 1999
</TABLE>
68
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 13,252
<SECURITIES> 17,273
<RECEIVABLES> 20,358
<ALLOWANCES> 3,516
<INVENTORY> 19,147
<CURRENT-ASSETS> 53,738
<PP&E> 25,177
<DEPRECIATION> 5,349
<TOTAL-ASSETS> 99,010
<CURRENT-LIABILITIES> 14,031
<BONDS> 211
0
0
<COMMON> 83,790
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 99,010
<SALES> 53,180
<TOTAL-REVENUES> 53,180
<CGS> 28,398
<TOTAL-COSTS> 53,934
<OTHER-EXPENSES> 60
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 183
<INCOME-PRETAX> 866
<INCOME-TAX> (1,647)
<INCOME-CONTINUING> 2,513
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,513
<EPS-PRIMARY> 0.14
<EPS-DILUTED> 0.14
</TABLE>
