Item 1. Business.
We are engaged in the development, manufacture and marketing of electronic products for use in the gaming and amusement markets. The Company was founded on August 22, 2003 and we completed our initial public offering on October 13, 2005. Our common stock began trading on October 14, 2005 and is currently listed on the NASDAQ Capital Markets under the ticker symbol PTEK. Our corporate office is located in Matthews, North Carolina. We also operate a Canadian subsidiary, PokerTek Canada, Inc. and derive a substantial portions of our revenues from Canada, Australia, and Europe. For the year ended December 31, 2008, revenues from customers outside the United States accounted for 63% of consolidated revenue. See Note 15, “Segment Information” in Item 8, “Financial Statements and Supplementary Data.”
We currently have two product lines - PokerPro® and Heads-Up Challenge™:
PokerPro®-The PokerPro system consists of electronic poker table(s) and related peripheral equipment providing commercial casinos, tribal casinos, cruise ships and card clubs with a fully-automated poker-room environment designed to improve the profitability of poker by enhancing operator revenue opportunities while decreasing startup and operating costs. We first introduced PokerPro in late 2005 and have continued to invest in features and innovations to enhance the player and operator experience. We distribute PokerPro domestically using our internal sales force to customers in the United States, Canada and cruise ships, generally on a recurring revenue lease model.
Internationally, we sell PokerPro to Aristocrat International Pty. Limited (“Aristocrat”) for distribution in most markets outside North America. Aristocrat is a leading global provider of gaming solutions including video slot machines, progressive systems and casino management systems and is a significant shareholder of the Company, owning approximately 16.4% of our outstanding common stock as of December 31, 2008. Aristocrat purchases the PokerPro tables from us and assumes responsibility for all marketing, regulatory, distribution and support in their markets.
As of December 31, 2008, there were 275 PokerPro tables, consisting of 177 PokerPro tables on lease with 16 gaming customers at 75 sites in the United States, Canada, and on major cruise lines and 98 PokerPro tables sold to Aristocrat for lease to its customers internationally.
Heads-Up Challenge™. Heads-Up Challenge is an innovative amusement platform that enables two players to compete head to head against each other for entertainment purposes in non-gambling venues such as bars and restaurants. We introduced Heads-Up Challenge in late 2007 as a Texas Hold’em Poker amusement game. We intend to develop other games to take advantage of the unique heads-up platform and to enhance our operators’ revenue opportunities. Bocce was added to the product offering during the fourth quarter of 2008.
We sell our Heads-Up Challenge product through a network of independent distributors throughout the world. We have signed arrangements with 15 distributors for the United States, Canada, the United Kingdom and the United States Military. In Australia and New Zealand, Aristocrat serves as our distributor for Heads-Up Challenge. As of December 31, 2008, we had sold an aggregate of 1,148 units since product launch.
PokerPro Gaming Products
Overview. Poker is one of several card games in which two or more players strategically bet against each other. Many casinos and card clubs operate poker rooms that typically consist of tables at which up to 10 players play any of several types of poker against the other players at the table. A dealer employed by the casino or card club is responsible for dealing cards, calculating bets, distributing payouts and collecting the amount the casino or card club charges as a service fee. Unlike most other games played at a casino, where the casino may win the full amount of a player’s bet, the casino or card club’s revenue from the poker room is limited to a service fee, typically a small amount taken from each pot (the “rake”) or a fixed amount charged at a regular interval. The poker rooms’ revenue directly correlates to the amount of hands / time played per day, not on the win-loss rate of player bets. Accordingly, poker typically generates lower relative profits for the casino operator than slot machines and other table games. Our gaming products seek to improve the profitability of poker by enhancing operator revenue opportunities while decreasing startup and operating costs.
The PokerPro system is an automated 10-seated poker table with electronic components that allows players to play poker against one another using electronic cards and chips. Each player position has a touch screen monitor to view their cards, betting options and other game information. The players use their touch screen monitor to input game decisions, make bets, and manage their account. In the center of the table is an LCD video screen which displays information such as chips bet by each player, total pot or pots and community cards dealt. Electronic cards are dealt to the players by a central server, which is physically separate from the table.
In addition to the table, the PokerPro system comes with a Cashless Wagering System (“CWS”), which creates and maintains player accounts and transacts cash-in and cash-out functions. A player who wants to play on the PokerPro system must first establish an account in the CWS and receive an account card. If a table seat is available, the player can insert his or her account card into the PokerPro player monitor, bring money to the table and begin playing. If the tables are full, the player can use an automated kiosk to get on a waiting list for the game he or she wants to play. There is a waiting list display which indicates where a player is in the queue and when a position becomes available, directs the player to the appropriate table.
The PokerPro system also has administrative tools which are designed to allow casino management to stop, start and monitor the poker games in progress. They allow management to choose the variety of poker being played, the betting limits and the number of players required to start a poker game. The administrative tools are also designed to track statistics about game play and specific players, such as the number of hands being played per hour and the average pot size of each game.
The PokerPro system currently allows players to play Texas Hold’em, Omaha, and Seven Card Stud poker and all games can be played as cash games, single-table tournaments or multi-table tournaments. The casinos or card clubs can offer these games in a variety of limits, including, no-limit, limit, spread limit and pot limit. Omaha can be played as high hand only, or high / low split pot. Seven Card Stud can be played as high hand only, high / low split pot, or Razz (low hand only). Poker games offered by the PokerPro system are completely configurable, so each game can be played in accordance with the same rules that apply to live poker games.
Market Opportunities. The game of poker has been increasing in popularity over the past several years. We believe PokerPro is an innovative product from both the casino and the player perspective and our goal is to capture a significant share of this growing market. . The table below presents the number of poker tables in our target markets worldwide (source is the Casino City Press, Winter 2009). Each market presents varying degrees of opportunity and operates under different regulatory guidelines.
During late 2008 and early 2009, overall economic conditions weakened in the United States and abroad, negatively impacting attendance and consumer spending in most gaming markets. Accordingly, as casino operators experience increased financial pressure, we expect that growth in poker tables could slow or reverse in 2009.
Commercial Casinos. North American commercial casinos have experienced significant growth in poker tables over the past five years. This segment of the market represents a significant market opportunity for us. The commercial casino market is highly regulated and approval from the date of initial application for commercial casinos can be up to 24 months or longer.
In 2008, the American Gaming Association (“AGA”) reported that, in the United States, there were 467 commercial casinos operating in 12 states that offered legalized gaming. Of the 12 states, Nevada and New Jersey were the largest commercial casino markets in North America in terms of gross gaming revenue with 270 casinos and 11 casinos, respectively.
In Canada, there were 63 commercial casinos operating in 8 provinces. We have regulatory approval to operate in commercial casinos in Quebec and are pursuing regulatory approval to operate in Ontario, as well as in the Canadian provinces operated by the Atlantic Lottery Corporation.
As of December 31, 2008, we had 87 PokerPro tables in commercial casinos in the United States and Canada.
Tribal Casinos. As of December 31, 2008, there were approximately 441 tribal gaming facilities in the United States and Canada.
As of December 31, 2008, we had 25 PokerPro tables in tribal casinos in Michigan and California.
Card Clubs. Several states, such as California, Washington, North Dakota, Minnesota and Montana, have card clubs that specialize in poker. California and Washington are the two largest card club markets in terms of revenue. As of December 2008, according to Casino City Press, California is the largest card club market in the United States, with 90 card clubs operating approximately 1,110 tables. In Washington, there are 90 card clubs operating approximately 272 tables.
As of December 31, 2008, we had 5 PokerPro tables located in card clubs in California.
Cruise Ships. As of December 2008, per the Casino City Press, there were 111 poker tables on approximately 146 ocean-going cruise ships in the world. Unlike other markets in which we operate, the cruise ship market is generally unregulated. We have PokerPro tables on several major cruise lines, including Carnival Corporation, Royal Caribbean and Norwegian, and we successfully completed installations on 100% of the Carnival Cruise Lines fleet during 2008.
As of December 31, 2008, we had 60 PokerPro tables located on 57 cruise ships.
International Casinos. According to the Casino City Press, as of December 2008, markets outside of North America and cruise ships contained 3,048 poker tables. We believe that international markets may grow faster than the North American markets in the future and represent a significant growth opportunity for PokerPro.
Aristocrat serves as our international distributor. Our distribution agreement provides Aristocrat with exclusive rights (excluding the United States, Canada and cruise ships) to distribute, market, enter into license agreements and, under certain circumstances, manufacture the PokerPro system.
As of December 31, 2008, we had sold an aggregate of 98 PokerPro tables to Aristocrat for lease to its international customers.
Competition. The overall market for gaming devices is mature and characterized by numerous competitors that develop and license proprietary table games. We are aware of several other companies in the United States and abroad offering automated poker products and additional competitive forces could join the market. Potential competitors include established manufacturers of gaming devices that may have widespread brand recognition and substantially greater resources and marketing capabilities than we have. In addition, they may have some of the regulatory approvals required to market and sell automated poker tables in our target markets. Potential competitors also could offer lower cost products manufactured in less regulated or lower cost foreign markets.
We also compete with gaming supply companies and with other gaming and entertainment products for space on the customers’ floor, as well as for the customers’ capital spending. Some of the larger gaming supply companies with whom we compete are International Game Technology, Progressive Gaming International, Shuffle Master, Inc. and WMS Industries, Inc.
In addition, we compete with internet poker websites and other forms of internet gaming.
Product Supply. We purchase all parts, including hardware components, table game felts, signs and accessories for the PokerPro system from third-party suppliers. We assemble the PokerPro system from such component parts at our facility in Matthews, North Carolina.
We believe that our facility has sufficient capacity to meet demand and that our sources of supply are adequate. Several key components we use in the manufacture of our products are proprietary and are currently assembled by a single contract manufacturer. Also, certain complex integrated circuits are manufactured by a single source and are critical to our product designs. Changing manufacturers for any of these components would require significant time and effort on the part of our management team, may require additional engineering development work, and could have a disruptive impact on our operations.
In addition, as part of an initiative underway to reduce our manufacturing costs, we are transitioning more of our components to the contract manufacturer that also produces our Heads-Up Challenge product, increasing our overall dependency on this supplier.
The components we use are produced primarily in Taiwan and China and are subject to long lead times and other issues associated with managing an international supply chain. Furthermore, we compete with other companies for the production capacity of third-party manufacturers and suppliers for displays and for other components.
Distribution Method. We distribute our gaming products to North American casinos and to cruise ships on a direct basis using our own internal sales force. We employ account managers who are assigned geographic sales territories and continue to be closely involved with our customers following the deployment of tables to provide advice and manage the overall customer relationship. We generally lease PokerPro to customers on a recurring revenue basis (either a fixed-fee lease or participation arrangement where we share the customers revenue on a percentage basis)
Outside of North America, we sell our PokerPro products to Aristocrat for distribution to its customers in those markets. Aristocrat purchases the PokerPro tables from us and assumes responsibility for marketing, regulatory compliance, distribution and support in their markets.
Heads-Up Challenge Amusement Products
Overview. Heads-Up Challenge is an innovative amusement platform that enables two players to compete head to head against each other for entertainment purposes in non-gambling venues such as bars and restaurants. We introduced Heads-Up Challenge in late 2007 as a Texas Hold’em Poker amusement game. We intend to develop other games to take advantage of the unique heads-up platform and to enhance our operators’ revenue opportunities.
Players can play no-limit Texas Hold’em with traditional poker action and realistic movements and sounds against one another for entertainment purposes. It can be played in single player mode, two player mode or tournament mode with up to 8 players. We are also developing other games for the Heads-Up Challenge platform and introduced Bocce in the fourth quarter of 2008. However, we can provide no assurance that additional games will be developed or will be successful.
We sell our Heads-Up Challenge product through a network of independent distributors throughout the world. We have signed arrangements with 15 distributors for the United States, Canada, the United Kingdom and the United States Military. In Australia and New Zealand, Aristocrat serves as our distributor for Heads-Up Challenge. As of December 31, 2008, we had sold an aggregate of 1,148 units since product launch.
Market Opportunities. The market for Heads-Up Challenge includes restaurants, bars and other amusement venues. There are an estimated 176,000 restaurants and bars worldwide as well as opportunities for other outlets, such as in homes.
Competition. The overall market for coin-in amusement game devices is mature and characterized by numerous competitors. We compete with other popular and more established games, such as Golden Tee and Big Buck Hunter, for a share of the operators’ capital spending. Some of these competitors are established manufacturers, including Incredible Technologies and Play Mechanics, Inc., that may have more widespread brand recognition and substantially greater resources and marketing capabilities than we have. We also compete with other games and activities for floor space in the bar or restaurant.
Product Supply. We purchase our Heads-Up Challenge tables from a contract manufacturer located in Taipei, Taiwan. The units are essentially complete and ready for sale when delivered. Our master distributors in the United States, Australia and the United Kingdom load software, install bill and coin validators and other minor steps to complete the table once received.
We believe that our contract manufacturer has ample capacity to meet demand and that sources of supply are adequate. However, because our supply chain crosses the ocean and we rely on a third party, our ability to meet demand is dependent on their performance as well as our ability to provide accurate production forecasts and manage long logistical lead times.
Distribution Method. We distribute our amusement products through a network of independent distributors. These distributors are generally given exclusive or non-exclusive rights to sell the product within a specified geographic territory (and typically we retain the right to make direct sales where applicable). The distributors typically sell the product to operators who place the products in restaurants, bars or other venues. The operator assumes responsibility for the operation and maintenance of the units following purchase.
As of December 31, 2008 we have signed arrangements with 15 distributors for the United States, Canada, the United Kingdom and the United States Military. Aristocrat distributes our amusement product in Australia and New Zealand.
We also sell units directly to consumers for home use and may establish direct relationships with larger corporate customers in the future.
Gaming Regulations and Licensing
Regulatory Overview. Generally, the manufacture, sale and use of gambling devices is subject to extensive federal, state, local and tribal regulation. In order to sell and distribute the PokerPro system to our target markets, we must comply with the applicable regulations of each jurisdiction in which we operate.
We normally expect regulatory approval in most jurisdictions to take up to 24 months or longer. The PokerPro system is a relatively new and innovative technology, increasing the difficulty to accurately predict the time and expense required to obtain approvals or licenses in any particular jurisdiction. Further, the laws and regulations of the jurisdictions in which we operate or intend to operate are subject to amendment and reinterpretation from time to time, and therefore it is possible that even if the PokerPro system is approved at one time, its use may be restricted, conditioned or prohibited in the future.
Some states prohibit playing poker or gambling in any form. We do not intend to sell or distribute the PokerPro system in these states or to Native American tribes located in these states unless such sales or distribution is specifically authorized by the tribal-state compact, a legally binding agreement between states and tribes.
The following is a brief description of the significant regulations that apply to us in the jurisdictions in which we are located or intend to market and sell the PokerPro system.
Federal Regulation. Gaming devices are governed by the Federal Gambling Devices Act of 1962 (the “Johnson Act”). The Johnson Act generally prohibits the transportation of a gambling device from one state to another unless the receiving state has legalized the use of the gambling device. The Johnson Act also requires registration for manufacturers of gaming devices.
Commercial Casinos. States that allow some form of casino-style gambling usually have extensive regulatory requirements that must be met before the PokerPro system can be marketed to commercial casinos located in these states. Generally, each state’s respective gaming commission requires that a license or finding of suitability be issued with respect to PokerTek as an entity, the PokerPro system, or both. Among those states that require regulatory approval for both PokerTek and the PokerPro system, some states consider such approval simultaneously, while others, such as Nevada, require that we obtain company approval before considering approval for the PokerPro system itself. Some states also require that gaming products be placed in the market on a trial basis before receiving final approvals. Some states require the licenses and findings of suitability to be renewed on a regular basis. State commissions can deny our applications for licenses and findings of suitability or revoke our licenses or prior findings of suitability for any cause.
If a state requires that we obtain company approval in addition to the product approval required for the PokerPro system, we are required to submit detailed financial and operating reports and furnish other information. Our officers, directors, certain key employees and any person having a material relationship with us may have to qualify with the state commission and obtain a finding of suitability. Our beneficial owners, especially beneficial owners of more than 5% of our outstanding common stock, may also be required to obtain a finding of suitability.
Tribal Casinos. Gaming on tribal lands is governed by the Indian Regulatory Gaming Act of 1988 (the “IGRA”), the National Indian Gaming Commission (the “NIGC”), specific tribal ordinances and regulations and, in some instances, agreements between Native American tribes and their respective states, referred to under the IGRA as a tribal-state compact.
The IGRA provides a statutory basis for Native American tribes to operate certain gaming activities, depending on how a particular game is classified and whether the laws of the state where the Native American tribe is located allow or prohibit the particular game. The gaming classifications are: Class I, Class II and Class III.
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Class I gaming include traditional Native American social and ceremonial games and are regulated only by the tribes.
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Class II gaming includes bingo and certain card games such as poker, so long as the card game is not prohibited by the laws of the state where the tribe is located, the card game is played somewhere in the state and the playing of the card game conforms to any applicable state law.
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Class III gaming consists of all forms of gaming that are not Class I or Class II, such as video lottery games, slot machines, most table games and keno.
The classification of a gaming device is determined by the operator in each jurisdiction.
We must also obtain certification from an Independent Testing Laboratory (“ITL”) prior to the installation of the PokerPro system in certain tribal jurisdictions. As discussed below, these were obtained in October 2006 with respect to the tribal jurisdictions in which we operate.
We must also become approved as a gaming supplier with each federally recognized tribe.
Card Clubs. States that allow poker to be played in card clubs have various regulatory requirements that apply to manufacturers of gambling devices similar to commercial casinos.
Cruise Ships. The cruise ship market is authorized under the Johnson Act, and not subject to regulatory oversight; therefore, the PokerPro system is currently under no regulatory restrictions aboard cruise ships.
International Casinos. Internationally, the regulatory environment is complex and varies by jurisdiction. Certain foreign countries permit the importation, sale and operation of gaming equipment in casino and non-casino environments.
In accordance with our distribution agreement, Aristocrat is responsible for managing the regulatory process and obtaining necessary approvals to sell or operate PokerPro tables in this market.
Regulatory Status. As of December 31, 2008, we have regulatory approval of the PokerPro system from British Columbia Gaming Policy & Enforcement, Société des Casinos du Québec Inc., Arkansas Racing Commission, State of California Gambling Control Commission, Connecticut Department of Revenue, the Iowa Racing and Gaming Commission and Indiana Gaming Commission, Louisiana Department of Public Safety and Corrections, Louisiana Department of Public Safety and Corrections - Indian Gaming Division, Michigan Gaming Control Board, Mississippi Gaming Commission, Nevada Gaming Control Board, Washington State Gambling Commission, West Virginia Lottery Commission, CA - Berry Creek Rancheria Gaming Commission, Cabazon Band of Mission Indians, Tuolumne Me-Wuk Tribal Gaming Agency, Viejas Tribal Gaming Commission; CT - Mashantucket Pequot - Connecticut Department of Revenue, Mohegan Tribe of Indians - Connecticut Department of Revenue; MI - Pokagon Band of Potawatomi Indians; NM - Pueblo of Laguna Tribal Gaming Regulatory Authority; OK - Choctaw Gaming Commission, Cherokee Nation Gaming Commission, Iowa Tribe of Oklahoma Gaming Commission; OR - Confederated Tribes Gaming Commission.
We have submitted applications seeking product approval of the PokerPro system and operating in a field trial status with the Louisiana State Police Gaming Division, New Jersey Casino Control Commission and the Nevada Gaming Control Board. Subsequent to December 31, 2008, we removed our tables from our field trial site in New Jersey, placing our regulatory progress on hold until a suitable partner is identified to continue the field trial.
We were notified by the Nevada Gaming Commission on March 19, 2009, that the PokerPro system had been approved by the commission.
We have petitioned the Washington State Gaming Commission for rule changes to allow the use of electronic poker tables in its commercial casinos.
For our international markets, as of December, 31, 2008, Aristocrat has regulatory approval in Australia, Bulgaria, Germany, Italy, Japan, Macau, Panama, Philippines, South Africa and United Kingdom and is in the process of seeking approval in several other jurisdictions, notably France and Switzerland.
We have received product certifications from Gaming Laboratories International (“GLI”) and BMM International (“BMM”), independent testing laboratories for our PokerPro products. Other certifications that we have received for our products, including electrical, communications and safety certifications, include:
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Conformité Européenne (“CE”), a mandatory European marking for certain product groups to indicate conformity with the essential health and safety requirements set out in European Directives;
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Federal Communications Commission (“FCC”), which regulates radio emissions of electronic devices;
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The RoHS Directive (“ROHS”), which bans the placing on the European Union market of new electrical and electronic equipment containing more than agreed levels of certain hazardous materials; and
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Underwriters Laboratories, Inc. (“UL”), a product safety compliance testing laboratory.
Corporate History
The Company was founded on August 22, 2003, by Gehrig H. “Lou” White, James T. Crawford and Arthur Lee Lomax. It was initially organized as a North Carolina corporation named National Card Club Corporation. During the period from March 19, 2004 through July 27, 2004, National Card Club Corporation owned a majority interest in an affiliated limited liability company called PokerTek, LLC. On July 27, 2004, PokerTek, LLC merged with and into National Card Club Corporation and each member of PokerTek, LLC received six shares of common stock for each unit of limited liability membership interest in PokerTek, LLC held by such member. The units of limited liability membership interest held immediately before the merger were cancelled. Simultaneous with this merger, the name was changed to PokerTek, Inc.
We completed our initial public offering on October 13, 2005 and our common stock now trades on the NASDAQ Capital Market under the ticker symbol “PTEK”.
Available Information
The Company is subject to the informational requirements of the Exchange Act. The Company therefore is required to file periodic reports, proxy and information statements and other information with the Securities and Exchange Commission (“SEC”). Such reports may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, N.E., Washington, DC 20549, or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.
The Company also maintains an internet site (www.pokertek.com) where interested parties can obtain copies of all reports, proxy and information statements and other information that the Company submits to the SEC. The information contained on, or that can be accessed through, our website is not incorporated by reference into this annual report. We have included our website address as a factual reference and do not intend it as an active link to our website.
Our corporate office is located at 1150 Crews Road, Suite F, Matthews, North Carolina 28105.
Research and Development
We have invested considerable time and resources on the research and development efforts necessary to invent and commercialize both PokerPro and Heads-Up Challenge. Our research and development expenses were $2.8 million, $4.0 million and $3.5 million during the fiscal years ended December 31, 2008, December 31, 2007 and December 31, 2006, respectively.
We continue to develop new releases and improvements to the PokerPro system, including designing additional varieties of poker and developing additional functionality for the PokerPro system. These development efforts are focused on improving operator revenue, enhancing the player experience, improving back-end operations and reporting for the operator, and complying with regulatory requirements.
We also began a hardware and software project in 2008 that is ongoing in 2009 to reengineer the PokerPro table to simplify its components and reduce the manufactured cost of table.
Heads-Up Challenge was commercialized in late 2007. We continue to work on the development of new games and improvements to the existing hardware and software platform and to reduce its cost to manufacture.
Intellectual Property
Trademarks. Gehrig H. "Lou" White, our Vice Chairman of the Board of Directors, and James Crawford, our President, jointly filed an application with the U.S. Patent and Trademark Office to register the PokerPro trademark. The trademark has been registered by the U.S. Patent and Trademark Office and an assignment of the trademark to PokerTek has been recorded.
Patents. We currently have applications for more than 40 patents before the U.S. Patent and Trademark Office which relate to various aspects of our products, though we are regularly refining the list of patents that we pursue because of factors such as passage of time, cost, and likelihood of issuance. Patent applications are costly, can take many years to issue and we can provide no assurance that any of these patents will actually be issued. As we continue to develop new technology, we may file additional patent applications with respect to such technology. Additionally, we have numerous foreign patent application equivalents pending in various non-U.S. jurisdictions.
Licenses.
World Poker Tour: WPT Enterprises, Inc. (“WPT”), which operates the World Poker Tour, granted PokerTek, LLC (our former affiliate) an exclusive, 10-year, royalty-free, non-sublicensable license to use the “World Poker Tour” name and related logo and trademark in connection with the lease, sale or distribution in the United States of tables featuring automated live poker games and tournaments. We can also market and offer certain WPT branded packaged deals to its prospective customers. The license was transferred to PokerTek, Inc. in July 2004. WPT may terminate the license in the event that we breach any material term of the license, we fail to adhere to WPT’s style guide for its logos and trademarks or if we become subject to bankruptcy proceedings (voluntary or involuntary) that are not dismissed within 30 days.
World Series of Poker: On April 17, 2007, Harrah’s License Company, LLC (“Harrah’s”) granted PokerTek, Inc. a limited, non-exclusive, non-transferable license with limited right of sublicense to utilize the “World Series of Poker®” name, related logos and trademarks in connection with the design, development, manufacture, marketing, advertisement, promotion and lease of our gaming tables worldwide. The license term is five years with three two-year options to renew. Harrah’s may terminate the license in the event that we become subject to bankruptcy proceedings (voluntary or involuntary) that are not dismissed within 30 days.
Other. We have registered the www.pokertek.com internet domain name.
Seasonality and Business Fluctuations
Our business is not generally subject to seasonality. However, quarterly revenue and net income may vary significantly based on the timing of regulatory approvals, product sales, the introduction of new products and changes in our installed base of PokerPro systems. In addition, approximately 13.1% of our revenues are derived from cruise ships, where casino play may vary from quarter to quarter depending on a number of factors, including the itinerary, length of cruises, and demographics of the passengers.
Backlog
The nature of our business does not lend itself to maintaining a significant backlog of unshipped orders.
Customer Dependence
As of December 31, 2008 we have 17 customers. Five of our customers made up approximately 75% of our total revenues. The loss of any of these customers or changes in our relationship with any of them could have a material adverse effect on our business.
Employees
As of December 31, 2008, we had 57 full-time employees, a reduction of 20 from 77 full-time employees as of December 31, 2007. Subsequent to the end of 2008, we further reduced our employee count to 39 during January 2009 as we continued to streamline our operations and reduce operating overhead.
We consider our relationships with our employees to be satisfactory. None of our employees are covered by a collective bargaining agreement.
Item 1A.
Item 1A. Risk Factors.
Our business is closely tied to the casino industry and factors that negatively impact the casino industry may also negatively affect our ability to generate revenues.
Casinos and other gaming operators represent a significant portion of our customers. Therefore, factors that may negatively impact the casino industry may also negatively impact our future revenues. If casinos experience reduced patronage, revenues may be reduced as our games may not perform well and may be taken off of the casino floor altogether. The level of casino patronage, and therefore our revenues, are affected by a number of factors beyond our control, including:
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general economic conditions;
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levels of disposable income of casino patrons;
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downturn or loss in popularity of the gaming industry in general, and table and slot games in particular;
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the relative popularity of entertainment alternatives to casino gaming;
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the growth and number of legalized gaming jurisdictions;
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local conditions in key gaming markets, including seasonal and weather-related factors;
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increased transportation costs;
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acts of terrorism and anti-terrorism efforts;
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changes or proposed changes to tax laws;
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increases in gaming taxes or fees;
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legal and regulatory issues affecting the development, operation and licensing of casinos;
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the availability and cost of capital to construct, expand or renovate new and existing casinos;
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the level of new casino construction and renovation schedules of existing casinos; and
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competitive conditions in the gaming industry and in particular gaming markets, including the effect of such conditions on the pricing of our games and products.
These factors significantly impact the demand for our products and technologies.
Our business would suffer if demand for gaming in general, or poker in particular, decreases.
We derive a significant portion of our revenues from the leasing, licensing and sale of the PokerPro system and from providing related maintenance and support services. Although the popularity of poker in particular and gaming in general has recently been growing in the United States and abroad, gaming has historically experienced backlash from various constituencies and communities. Public tastes are unpredictable and subject to change and may be affected by changes in the country’s political and social climate. A change in public tastes or a backlash among certain constituencies or in certain communities could result in reduced popularity of poker or increased regulation of the gaming industry, either of which could significantly reduce demand for the PokerPro system.
Moreover, the market for the PokerPro system is limited; according to Casino City Press, as of December 2008, there were approximately 7,135 poker tables operating in the United States and Canada and 3,048 outside the United States and Canada. Although we believe that this represents a significant opportunity for the PokerPro system, the number of venues in which the PokerPro system can be placed is finite, as the number of jurisdictions in which gaming is legal is limited.
During late 2008 and continuing into 2009, the global economy experienced a significant downturn that has impacted attendance and consumer spending on gaming and other leisure activities. Casino operators are experiencing unprecedented financial pressure which may lead them to curtail operations, close facilities, delay poker room conversions, or be unable to meet their financial obligations. In addition, reductions in consumer spending may impact the ability of amusement operators to generate acceptable returns or continue to operate their businesses. Our vendors are also under increased financial pressure, which could impact their ability to operate their businesses or deliver products to us.
We derive a significant portion of our revenues from the leasing, licensing and sale of the PokerPro system and from providing related maintenance and support. Gaming revenues and occupancy in major gaming markets have declined significantly, causing many casino operators to reevaluate their operations, reduce expenses, and in some cases to cease operations or seek bankruptcy protection. We also believe that operators in the amusement markets are experiencing increasing financial pressures and believe that many operators have limited financial resources and would be adversely impacted by a sustained economic downturn. During early 2009, we believe that some smaller operators have been forced to curtail or cease operations. We also understand that electronics and other vendors in the Far East are experiencing significant declines in demand from their international customers, which could possibly impact their ability to manufacture and deliver products efficiently and at acceptable costs.
A prolonged decline in consumer spending on gaming and amusement activities could have a significant impact on our customers and our vendors. Accordingly, such a prolonged downturn could have a significant impact our business operations and financial condition.
We recently entered into new debt financing arrangements, which could have a material adverse effect on our financial health and our ability to obtain financing in the future, and may impair our ability to react quickly to changes in our business.
We entered into a loan and two credit facilities during 2008, introducing certain risks associated with debt financing. As of December 31, 2008, we had $4.9 million in debt outstanding. and we had the ability to borrow additional funds. Our increased exposure to debt financing could limit our ability to satisfy our obligations, limit our ability to operate our business and impair our competitive position. For example, it could:
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increase our vulnerability to adverse economic and industry conditions, including interest rate fluctuations, because a portion of our borrowings are at variable rates of interest;
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require us to dedicate future cash flows to the repayment of debt. This could reduce the availability of cash to fund working capital, capital expenditures or other general corporate purposes;
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limit our flexibility in planning for, or reacting to, changes in our business and industry; and
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limit our ability to obtain additional debt or equity financing due to applicable financial and restrictive covenants contained in our debt agreements.
Despite current indebtedness levels, we may also incur additional indebtedness in the future, which could materially increase the impact of these risks on our financial condition and results of operations.
Our ability to repay our debt depends on many factors beyond our control. If we elect to raise equity capital in the future, our current shareholders could be subjected to significant dilution. If we are unable to raise capital in the future, we may seek other avenues to fund the business, including sale/leaseback arrangements, transitioning PokerPro from a capital intensive leasing strategy to a product sale strategy, or seeking to sell assets of all, or a portion of, our operations.
Payments on our debt will depend on our ability to generate cash or secure additional financing in the future. This ability, to an extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond our control. If our business does not generate sufficient cash flow from operations, and sufficient future financing is not available to us, we may not be able to repay our debt, operate our business or fund our other liquidity needs. If we cannot meet or refinance our obligations when they become due, this may require us to attempt to raise capital, sell assets, reduce expenditures or take other actions which we may be unable to successfully complete or, even if successful, could have a material adverse effect on us. If such sources of capital are not available or not available on sufficiently favorable terms, we may seek other avenues to fund the business, including sale/leaseback arrangements, transitioning PokerPro from a capital intensive leasing strategy to a product sale strategy, or seeking to sell assets of all, or a portion of, our operations. If we decide to raise capital in the equity markets or take other actions, our shareholders could incur significant dilution or diminished valuations, or, if we are unable to raise capital, our ability to effectively operate our business could be impaired.
In addition, based on the recent trading price of our common stock, if we are successful in raising capital in the equity markets to repay our indebtedness, or for any other purpose in the future, our shareholders would incur significant dilution.
The agreements and instruments governing our debt contain restrictions and limitations which could significantly impact our ability to operate our business.
Our credit facility with Silicon Valley Bank contains a number of significant covenants that could adversely impact our business by limiting our ability to obtain future financing, withstand a future downturn in our business or the economy in general, conduct operations or otherwise take advantage of business opportunities that may arise. The credit facility includes covenants requiring the achievement of specified financial ratios and thresholds and contains other terms and conditions qualifying the terms upon which Silicon Valley Bank is required to extend funds. Our ability to comply with these provisions may be affected by events beyond our control.
We are dependent on a small number of key suppliers and customers. Changes in our relationships with these parties, or changes in the economic environments in which they operate, could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our revenues are concentrated with a small number of customers. As of December 31, 2008, five of our customers made up approximately 75% of our total revenues. The loss of any of these customers or changes in our relationship with them could have a material adverse effect on our business.
To manufacture our casino and amusement products, we purchase components from independent manufacturers, many of whom are located in the Far East. An extended interruption in the supply of these products or suitable substitute inventory would disrupt our operations, which could have a material adverse effect on our business, financial condition and results of operations.
For a number of our inventory components, and for all of our Heads-Up Challenge finished goods, we rely on a single supplier. We are currently transitioning the manufacturing of more of our components to this supplier, increasing our dependence on that third party. We cannot estimate with any certainty the length of time that would be required to establish alternative supply relationships, or whether the quantity or quality of materials that could be so obtained would be sufficient. Furthermore, we may incur additional costs in sourcing materials from alternative producers. The disruption of our inventory supply, even in the short term, could have a material adverse effect on our business, financial condition and results of operations.
A significant portion of our business is conducted with customers and suppliers located outside of the United States. Currency, economic, political and other risks associated with our international operations could adversely affect our operating results.
Our revenues from international customers and our inventory costs from international suppliers are exposed to the potentially adverse effects of currency exchange rates, local economic conditions, political instability and other risks associated with doing business in foreign countries. To the extent that our revenues and purchases from international business partners increase in the future, our exposure to changes in foreign economic conditions and currency fluctuations will increase.
Our dependence on foreign customers and suppliers means, in part, that we may be affected by changes in the relative value of the U.S. dollar to foreign currencies. Although our receipts from foreign customers and our purchases of foreign products are principally negotiated and paid for in U.S. dollars, changes in the applicable currency exchange rates might negatively affect the profitability and business prospects of our customers and vendors. This, in turn, might cause such vendors to demand higher prices, delay shipments, or discontinue selling to us. This also might cause such customers to demand lower prices, delay or discontinue purchases of our products or demand other changes to the terms of our relationships. These situations could in turn ultimately reduce our revenues or increase our costs, which could have a material adverse effect on our business, financial condition and results of operations.
We have reported significant deficiencies in internal control over financial reporting, which could materially impact our financial reporting ability.
We have reported four significant deficiencies in internal control over financial reporting in Item 9A (T), “Controls and Procedures” in this annual report on Form 10-K.
While we are implementing new systems and taking other steps to strengthen our internal controls, we can provide no assurance that any or all new systems will be fully deployed or that the implementation of new systems and other procedures will fully resolve all significant deficiencies or that we will not create or discover additional significant deficiencies during that transition. If we are unable to remediate those significant deficiencies or if we discover other deficiencies, our ability to accurately report financial information could be impaired.
We have a limited operating history and a history of losses. We may be unable to generate sufficient net revenue in the future to achieve or sustain profitability.
We have experienced net losses for each quarterly and annual period since our inception in August 2003. To continue our business plan and generate increased revenues, we must obtain necessary regulatory approvals and customer commitments in many additional jurisdictions. The timing of our revenue generation will be driven in part by our receipt of such approvals in additional jurisdictions and entry into definitive agreements with customers in those jurisdictions. We anticipate that we will continue to incur losses and cash flow deficits during 2009. For the reasons discussed above and elsewhere in this report, it is possible that we may not generate significant revenues or profits in the foreseeable future or at all. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis, and our failure to do so would adversely affect our business and the market price of our common stock and may require us to raise additional capital, which may not be available on terms acceptable to us or at all.
Our success depends on the PokerPro system achieving and maintaining widespread acceptance by casinos and poker players.
Our success depends to a large extent on broad market acceptance of the PokerPro system among casinos and poker players. Even if we demonstrate the effectiveness of the PokerPro system and our business model, casinos and poker players may still not use the PokerPro system for a number of other reasons, including preference for live dealers, mistrust of technology and perceived lack of reliability. We believe that increased acceptance of the PokerPro system by casinos and poker players will depend on the following factors:
·
our ability to demonstrate the PokerPro system’s economic and other benefits to casinos;
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players becoming comfortable with using the PokerPro system; and
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the reliability of the hardware and software comprising the PokerPro system.
If we fail to obtain or maintain gaming licenses and regulatory approvals, we will be unable to operate the PokerPro segment of our business and license or sell our gaming products.
The manufacture and distribution of gaming machines is subject to extensive federal, state, local and tribal regulation. Most jurisdictions require licenses, permits and other forms of approval for gaming devices. Most, if not all, jurisdictions also require licenses, permits and documentation of suitability, including evidence of financial stability, for the manufacturers and distributors of such gaming devices and for their officers, directors, major shareholders and key personnel. Our failure to obtain regulatory approval in any jurisdiction will prevent us from distributing our products and generating gaming revenue in that jurisdiction.
Any registrations, licenses, approvals or findings of suitability that we currently have or may obtain in the future may be revoked, suspended or conditioned at any time. The revocation or denial of a license in a particular jurisdiction will prevent us from distributing the PokerPro system in that jurisdiction, and could adversely affect our ability to obtain and/or maintain licenses in other jurisdictions.
Gaming authorities in multiple jurisdictions have determined that certain of our executive officers, key employees, directors and significant shareholders are suitable. The inability of an executive officer, key employee, director or significant shareholder to obtain a determination of suitability in a jurisdiction may adversely affect the sale or licensing of our gaming products in that jurisdiction.
Gaming authorities in some jurisdictions may investigate any individual who has a material relationship with us and any of our shareholders to determine whether the individual or shareholder is suitable to those gaming authorities. Certain of our executive officers, key employees, directors and significant shareholders have been found suitable in multiple jurisdictions by various gaming authorities. If a gaming authority in any jurisdiction fails to find any of our executive officers, key employees, directors or significant shareholders suitable, we may be prohibited from leasing, licensing or selling our gaming products in that jurisdiction.
A finding of suitability is generally determined based upon numerous facts and circumstances surrounding the entity or individual in question and many gaming authorities have broad discretion in determining whether a particular entity or individual is suitable. We are unaware of circumstances that would categorically prevent a gaming authority from finding any of our officers, key employees, directors or significant shareholders suitable.
Gehrig H. “Lou” White, our Vice Chairman of the Board of Directors and beneficial owner of approximately 19.3% of our common stock, has disclosed in applications for the determination of suitability filed with gaming authorities that the IRS has recently completed an examination of his 2000 and 2001 federal individual income tax returns. The IRS previously issued an examination report showing a proposed income tax deficiency for Mr. White’s 2000 federal income tax return of $410,215 (plus additional interest and penalties attributable to that underpayment of tax) based on a disallowance of certain deductions for charitable contributions that Mr. White made to a foundation he established and mortgage interest that Mr. White paid to Legacy Capital, LLC, an affiliate of Merrill Scott. Merrill Scott is an investment advisor that was placed under receivership in 2002 by the SEC for violations of a variety of federal securities laws in connection with fraud and misappropriations of client funds by the firm through a scheme in which it obtained funds from its clients seeking above-market returns and other benefits. Mr. White is currently appealing the IRS’s proposed income tax deficiency. The IRS examination of Mr. White’s 2001 federal tax return resulted in the issuance of a notice of deficiency for additional income tax in the amount of $75,445 (plus additional interest and penalties attributable to that underpayment of tax). In his original 2001 federal tax return, Mr. White claimed deductions relating to a partnership investment he made after receiving advice from a law firm. The law firm subsequently informed Mr. White that the IRS had challenged the tax treatment of the investment structure and that he should file an amended return. Mr. White then filed an amended federal income tax return for 2001 eliminating the deductions relating to the partnership investment. He also paid the federal income taxes resulting from the elimination of such deductions. The IRS notice of deficiency assessed additional income taxes as the result of disallowing deductions for tax advice in connection with the partnership investment transaction and an accuracy penalty in connection with the losses claimed with respect to that investment. These amounts have been paid, which completes the audit process for Mr. White’s 2001 return. Due to the broad discretionary powers of gaming authorities, it is unknown what effect the IRS examinations of Mr. White’s federal income tax returns may have on Mr. White’s applications for a determination of suitability.
If any of our executive officers, certain key employees, directors or significant shareholders is not found suitable in a jurisdiction requiring a finding of suitability, we would be prevented from leasing, licensing or selling our gaming products in that jurisdiction as long as the individual or entity in question remained an officer, key employee, director or a significant shareholder. Such an occurrence would likely delay introduction of our gaming products into such jurisdiction or prevent us from introducing our gaming products in such jurisdiction altogether. Depending on how material such jurisdiction is to our plan of operations, failure to obtain such findings of suitability could have a material adverse effect on our results of operations. In addition, a finding that one of our executive officers, certain key employees, directors or significant shareholders is not suitable in any jurisdiction may hinder our ability to obtain necessary regulatory approvals in other jurisdictions. Conversely, however, a finding of suitability by one or more gaming authorities does not ensure that similar suitability determinations will be obtained from any other gaming authorities.
Although we have the ability to terminate the employment of an executive officer or key employee in the event that such executive officer or key employee fails to be found suitable, such termination would disrupt the management of our company, may trigger severance provisions under certain employment agreements and would likely have an adverse effect on our business and results of operations. In addition, the removal of a director under the provisions of our Amended and Restated Bylaws requires action on the part of our shareholders at a shareholders’ meeting. Our Amended and Restated Articles of Incorporation provide that we may redeem at fair market value any or all shares of our capital stock held by any person or entity whose status as a shareholder, in the opinion of our Board of Directors, jeopardizes the approval, continued existence, or renewal of any federal, state, local or tribal license we hold. However, we may not have the funds available for such a redemption, especially if the shareholder in question holds a significant amount of our common stock. We have not determined what action we would take in such event. We will also be prevented from effecting such a redemption if it would violate North Carolina law.
If the Johnson Act is found to apply to the PokerPro system, the Department of Justice may institute criminal and/or civil proceedings against us.
Gaming devices are regulated at the federal level by the Johnson Act. The Johnson Act broadly defines an illegal gambling device as any machine or mechanical device designed and manufactured primarily for use in connection with gambling and that, when operated, delivers money or other property to a player as the result of the application of an element of chance. We believe the Johnson Act does not apply to the use of the PokerPro system by tribal casinos because several courts have held that electronic aids to permitted Class II gaming devices under the IGRA are not prohibited by the Johnson Act. However, there is no guarantee that our belief is correct. These decisions have focused on the use by tribal casinos of electronic aids to bingo. We are not aware of any court or regulatory body that has considered how the Johnson Act applies to the PokerPro system or any other form of electronic poker table. The Department of Justice, the primary law enforcement entity responsible for enforcing the Johnson Act, has traditionally taken a broad view as to what constitutes a gambling device prohibited by the Johnson Act. It is possible that the Department of Justice may institute criminal and/or civil proceedings against us and that a court may rule that the Johnson Act prohibits the use of the PokerPro system by tribal casinos unless the tribe and state have entered into an appropriate tribal-state compact. Any such proceedings could interfere with our ability to obtain necessary regulatory approvals.
We could face substantial competition, which could reduce our market share and negatively impact our net revenue.
There are a number of companies that offer poker-related entertainment or manufacture and distribute automated gaming machines. Most of these companies have greater financial resources than we have. The primary barriers to entry are the establishment of relationships with the owners and operators of casinos and card clubs, the receipt of necessary regulatory approvals and the development of the technology necessary to create an automated poker table. It is likely that our potential competitors could include manufacturers of gaming devices that have already established such relationships and that have received some, if not all, of the regulatory approvals that would be required to market and sell automated poker tables in our target markets. In addition, most of these companies have greater financial resources than we have. Therefore, the barriers to entry discussed above may not pose a significant obstacle for such manufacturers if they sought to compete with us.
If we fail to protect our intellectual property rights, competitors may be able to use our technology, which could weaken our competitive position, reduce our net revenue and increase our costs.
Our long-term success will depend to a large degree on our ability to protect the proprietary technology that we have developed or may develop or acquire in the future. We currently have applications for more than 40 patents pending before the U.S. Patent and Trademark Office that relate to various aspects of the PokerPro system. Patent applications can take many years to issue and we can provide no assurance that any of these patents will be issued. If we are denied any or all of these patents, we may not be able to successfully prevent our competitors from imitating the PokerPro system or using some or all of the processes that are the subject of such patent applications. Such imitation may lead to increased competition within the finite market for the PokerPro system. Even if our pending patents are issued, our intellectual property rights may not be sufficiently comprehensive to prevent our competitors from developing similar competitive products and technologies. Although we may aggressively pursue anyone whom we reasonably believe is infringing upon our intellectual property rights, initiating and maintaining suits against third parties that may infringe upon our intellectual property rights will require substantial financial resources. We may not have the financial resources to bring such suits and if we do bring such suits, we may not prevail. Regardless of our success in any such actions, we could incur significant expenses in connection with such suits.
Third party claims of infringement against us could adversely affect our ability to market our products and require us to redesign our products or seek licenses from third parties.
We are susceptible to intellectual property lawsuits that could cause us to incur substantial costs, pay substantial damages or prohibit us from distributing our products. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. In addition, because patent applications can take many years to issue, there may be applications now pending of which we are unaware, which later may result in issued patents that our products may infringe. If any of our products infringe a valid patent, we could be prevented from distributing that product unless and until we can obtain a license or redesign it to avoid infringement. A license may not be available or may require us to pay substantial royalties. We also may not be successful in any attempt to redesign the product to avoid any infringement. Infringement and other intellectual property claims, with or without merit, can be expensive and time-consuming to litigate, and we may not have the financial and human resources to defend ourselves against any infringement suits that may be brought against us.
Defects in, and fraudulent manipulation of, the PokerPro system could reduce our revenue, increase our costs, burden our engineering and marketing resources, involve us in litigation and adversely affect our gaming licenses.
Our success will depend on our ability to avoid, detect and correct software and hardware defects and prevent fraudulent manipulation of our products. The PokerPro system is subject to rigorous internal testing, and additional testing by regulators in certain gaming jurisdictions. We may not be able to maintain products that are free from defects or manipulation and that continue to satisfy these tests. Although we have taken steps to prevent defects, our products could suffer such defects and our PokerPro products could be subject to manipulation after they have been widely distributed.
Although we do not believe it is likely, it is possible that an individual could breach the security systems of a casino or card club, gain access to the server on which the PokerPro system operates and fraudulently manipulate its operations. The occurrence of such fraudulent manipulation or of defects or malfunctions could result in financial losses for our customers and the subsequent termination of agreements, cancellation of orders, product returns and diversion of our resources. Even if our customers do not suffer financial losses, customers may replace our products if they do not perform according to expectations. Any of these occurrences could also result in the loss of or delay in market acceptance of our products, loss of sales and, in the case of gaming products, loss of regulatory approvals.
In addition, the occurrence of defects in, or fraudulent manipulation of, the PokerPro system and its associated software may give rise to claims for lost revenues and related litigation by our customers and may subject us to investigation or other disciplinary action by regulatory authorities that could include suspension or revocation of our regulatory approvals.
If the network infrastructure of certain of the casinos in which the PokerPro system is or will be installed proves unreliable, market acceptance of the PokerPro system would be materially and adversely affected.
We have entered into agreements with customers that operate casinos and card clubs in more than one location. In such cases, our agreement with such customer provides that such customer will be responsible for providing, at its expense, a dedicated high-speed connection between the tables comprising the PokerPro system in the various locations operated by the customer to a remote central server supporting such tables. Failures or disruptions of a customer’s dedicated high-speed connection that result in the stoppage of play or in reduced performance of the PokerPro system could reduce players’ gaming experience, adversely affect the casinos’ or card clubs’ satisfaction with automated gaming devices in general and delay or prevent market acceptance of the PokerPro system.
The use of the PokerPro system could result in product liability claims that could be expensive and that could damage our reputation and harm our business.
Our business exposes us to the risk of product liability claims. Subject to contractual limitations, we will face financial exposure to product liability claims if the PokerPro system fails to work properly and causes monetary damage to either poker players or casinos and card clubs. In addition, defects in the design or manufacture of the PokerPro system might require us to recall each PokerPro system that has been licensed. Although we maintain product liability insurance, the coverage limits of policies available to us may not be adequate to cover future claims. If a successful claim brought against us is in excess or outside of our insurance coverage, we may be forced to divert resources from the development of the PokerPro system, the pursuit of regulatory approvals and other working capital needs in order to satisfy such claims.
The loss of key personnel or the inability of replacements to quickly and successfully perform in their new roles could adversely affect our business.
All of our existing personnel, including our executive officers, are employed on an “at-will” basis. If we lose or terminate the services of one or more of our current executives or key employees or if one or more of our current or former executives or key employees joins a competitor or otherwise competes with us, it could impair our business and our ability to successfully implement our business plan. Additionally, if we are unable to timely hire qualified replacements for our executive and other key positions, our ability to execute our business plan would be harmed. Even if we can timely hire qualified replacements, we would expect to experience operational disruptions and inefficiencies during any transition.
Our management team’s limited experience in this market could increase costs, hamper our marketing strategies and delay our expansion.
The limited experience of our management team in the gaming industry and the market for automated game technology could result in increased operating and capital costs, difficulties in executing our operating and marketing strategies and delays in our expansion strategy. We may not successfully address any or all of the risks posed by this limited experience, and our failure to do so could seriously harm our business and operating results.
If we fail to manage our growth, our business and operating results could be harmed.
We have experienced rapid growth placing significant demands on our operational and financial infrastructure. If we do not effectively manage our growth, our ability to develop and market the PokerPro system and the Heads-Up Challenge products could suffer, which could negatively affect our operating results.
Our success will depend on the reliability and performance of third-party distributors, manufacturers and suppliers.
We compete with other companies for the production capacity of third-party suppliers for components. Certain of these competing companies have substantially greater financial and other resources than we have and thus we may be at a competitive disadvantage in seeking to procure production capacity. Our inability to contract with third-party manufacturers and suppliers to provide a sufficient supply of our products on acceptable terms and on a timely basis could negatively impact our relationships with existing customers and cause us to lose revenue-generating opportunities with potential customers.
We also currently rely on Aristocrat, a third-party distributor, to obtain regulatory approvals, market and distribute our PokerPro system outside of the United States and Canada. If Aristocrat is unsuccessful in marketing and distributing our products, we may miss revenue-generating opportunities that might have been recognized by another third-party distributor.
We also rely on Aristocrat and our other distributors to market and distribute our Heads-Up Challenge product. If our distributors are unsuccessful in marketing and distributing our product, we may miss revenue-generating opportunities that might otherwise have been recognized.
Our failure to obtain any necessary additional financing would have a material adverse effect on our business.
In order to execute our business plan, we may need to seek additional equity or debt financing. We may not be able to obtain such additional equity or debt financing when we need it or at all. Even if such financing is available, it may not be available on terms that are favorable to us or in sufficient amounts to satisfy our requirements. If we require, but are unable to obtain, sufficient additional financing in the future we may be unable to further protect our intellectual property sufficiently, meet customer demand for PokerPro systems or withstand adverse operating results. More importantly, if we are unable to raise further financing when required, our continued operations may have to be scaled down or even terminated and our ability to generate revenues would be negatively affected.
Enforcement of remedies or contracts against Native American tribes could be difficult.
Contracts with Native American tribes are subject to sovereign immunity and tribal jurisdiction. If a dispute arises with respect to any of those agreements, it could be difficult for us to protect our rights. Native American tribes generally enjoy sovereign immunity from suit similar to that enjoyed by individual states and the United States. In order to sue a Native American tribe (or an agency or instrumentality of a Native American tribe), the tribe must have effectively waived its sovereign immunity with respect to the matter in dispute. Moreover, even if a Native American tribe were to waive sovereign immunity, such waiver may not be valid and in the absence of an effective waiver of sovereign immunity by a Native American tribe, we could be precluded from judicially enforcing any rights or remedies against that tribe.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
We currently lease our corporate office and manufacturing facility. This facility is approximately 21,600 square feet and is located in Matthews, North Carolina. Our leased space is in good order and condition, and is adequate to satisfy our current needs. This facility is leased from an entity owned and controlled by our President and our Vice Chairman of the Board of Directors (see Note 12 - “Related Party Transactions”).
We also leased a small storage facility in Matthews, North Carolina during 2008. This lease was terminated as of January 31, 2009.
Item 3.
Item 3. Legal Proceedings.
On March 17, 2008, we were served with a complaint filed on March 6, 2008, in the United States District Court for the District of New Jersey by Lightning Gaming, Inc. and Lightning Poker, Inc. The complaint alleged that PokerTek infringed United States Patent No. 7,306,516, owned by Lightning Poker, Inc. The complaint sought unspecified monetary damages from PokerTek as well as a permanent injunction enjoining PokerTek from infringing the patent or unfairly competing with the plaintiffs. PokerTek believes that either its products do not violate the patent that forms the basis of the lawsuit, that the patent is invalid, or both.
On October 16, 2008, PokerTek announced that it had reached a mutually agreeable settlement of all outstanding litigation with Lightning Gaming, Inc. The settlement resulted in all lawsuits between the parties being withdrawn with prejudice.
There was no material financial impact to PokerTek as a result of the settlement.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Stock Listing
As of December 8, 2008, our common stock is traded on the NASDAQ Capital Market under the symbol PTEK. Our stock was previously traded on the NASDAQ Global Market. The table below shows the high and low sales prices for our common stock for the periods indicated, as reported by the NASDAQ Global Market and Capital Market.
As of March 12, 2009, there were approximately 1,100 holders of record of our common stock.
Transfer Agent
Our transfer agent is American Stock Transfer & Trust Company, located at 59 Maiden Lane, Plaza Level, New York, New York 10038, (800) 937-5449.
Dividends
To date no cash dividends have been paid with respect to our common stock and the current policy of the Board of Directors is to retain any earnings to provide for the growth of the Company. The payment of cash dividends in the future, if any, will depend on factors such as earnings levels, capital requirements, our overall financial condition and any other factors deemed relevant by our Board of Directors.
Item 6.
Item 6. Selected Financial Data.
The following selected financial data has been derived from audited financial statements for the years ended December 31, 2008, 2007, 2006, 2005, and 2004. The selected financial data set forth below should be read together with Item 7
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward-Looking Statements
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements sometimes include the words “may,” “will,” “estimate,” “intend,” “continue,” “expect,” or “anticipate,” and other similar words. Statements expressing expectations regarding our future (including pending gaming and patent approvals) and projections relating to products, sales, revenues and earnings are typical of such statements.
All forward-looking statements are subject to the risks and uncertainties inherent in predicting the future. Our actual results may differ materially from those projected, stated or implied in these forward-looking statements as a result of many factors, including, but not limited to, overall industry environment, customer acceptance of our products, delay in the introduction of new products, the further approvals of regulatory authorities, adverse court rulings, production and/or quality control problems, the denial, suspension or revocation of permits or licenses by governmental authorities, competitive pressures and general economic conditions and our financial condition. Please see Item 1A, “Risk Factors” for additional information regarding some of the risks and uncertainties to which we are subject.
Forward-looking statements speak only as of the date they are made. We undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur, and you are urged to review and consider disclosures that we make in this and other reports that discuss factors germane to our business.
Overview
We are engaged in the development, manufacture and marketing of electronic products for use in the gaming and amusement markets. We currently have two product lines - PokerPro and Heads-Up Challenge:
PokerPro®-The PokerPro system consists of electronic poker table(s) and related peripheral equipment providing commercial casinos, tribal casinos, cruise ships and card clubs with a fully-automated poker-room environment designed to improve the profitability of poker by enhancing the operator’s revenue opportunities and decreasing their startup and operating costs. We first introduced PokerPro in late 2005 and have continued to invest in features and innovations to enhance the player and operator experience. We distribute PokerPro using our internal sales force to customers in the United States, Canada and cruise ships, generally on a recurring revenue lease model.
Internationally, we sell PokerPro to Aristocrat for distribution in most markets outside North America. Aristocrat is a leading global provider of gaming solutions including video slot machines, progressive systems and casino management systems and a significant shareholder of the company, owning approximately 16.4% of our common stock as of December 31, 2008. Aristocrat purchases the PokerPro tables from us and assumes responsibility for all marketing, regulatory, distribution and support in their markets.
As of December 31, 2008, there were 275 PokerPro tables, consisting of 177 PokerPro tables on lease with 16 gaming customers at 75 sites in the United States, Canada, and on major cruise lines and 98 PokerPro tables sold to Aristocrat for lease to its customers internationally.
Heads-Up Challenge™. Heads-Up Challenge is an innovative amusement platform that enables two players to compete head to head against each other for entertainment purposes in non-gambling venues such as bars and restaurants. We introduced Heads-Up Challenge in late 2007 as a Texas Hold’em Poker amusement game. We intend to develop other games to take advantage of the unique heads-up platform and to enhance our operators’ revenue opportunities. Bocce was added to the product offering in late 2008.
We sell our Heads-Up Challenge product through a network of independent distributors throughout the world. We have signed arrangements with 15 distributors for the United States, Canada, the United Kingdom and the United States Military. In Australia and New Zealand, Aristocrat serves as our distributor for Heads-Up Challenge. As of December 31, 2008, we had sold an aggregate of 1,148 units since product launch.
General Economic and Industry Conditions: During the second half of 2008, global macroeconomic conditions deteriorated rapidly and significantly as a result of challenges in the banking industry, the crisis in the housing market, the decline in the stock market, tightening in the credit markets, inflationary pressures from higher energy, food and fuel costs, disappointing labor market conditions, and an uncertain geopolitical environment. Consumer confidence has suffered and spending on discretionary purchases, including gaming and amusement activities, has declined significantly.
Despite deteriorating economic conditions during 2008, we experienced significant growth in both of our product lines, increasing our PokerPro table count by 46% to 275 and launching Heads-Up Challenge, selling 1,108 units in 2008 as compared to 40 in 2007. However, we expect economic weakness will continue through the first half of 2009, if not longer, which may impact revenues from existing customers as well as our ability to attract new customers. Changes in consumer confidence and spending and/or significant changes in the gaming and amusement markets could have a material impact on our future consolidated financial position, results of operations or cash flows.
Results of Operations for the Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
Revenue. Revenue increased by $10.4 million (260%) to $14.4 million for the year ended December 31, 2008 as compared to $4.0 million for the year ended December 31, 2007 due to increases in both license and service fees and product sales.
License and service fees increased by $3.9 million (155%) to $6.4 million for the year ended December 31, 2008 as compared to $2.5 million for the year ended December 31, 2007. The increase in license and service fees was driven primarily by growth in the number of PokerPro systems deployed in casinos in the United States, Canada and on cruise ships.
Product sales increased by $6.6 million (434%) to $8.1 million for the year ended December 31, 2008 as compared to $1.5 million for the year ended December 31, 2007. Product sales consist of casino products, primarily PokerPro systems sold to Aristocrat for deployment in international casinos, as well as sales of our Heads-Up Challenge amusement product. The growth in product sales was attributable to both the successful launch of the new Heads-Up Challenge amusement product in late 2007 and growth of Aristocrat’s PokerPro business internationally. Heads-Up Challenge contributed $4.8 million in revenue for the year ended December 31, 2008 with 1,108 units sold, as compared to product sales revenue of $185,399 and 40 units sold for the year ended December 31, 2007. Sales of casino products amounted to $3.3 million, an increase of $2.0 million (150%) over the comparable period in 2007. Sales of casino products increased largely due to Aristocrat’s increasing penetration in several European markets, notably Bulgaria where poker was just recently legalized.
Direct Cost of Revenue. Direct cost of revenue consist of depreciation of PokerPro systems and the cost of PokerPro systems sold primarily to Aristocrat and the cost of Heads-Up Challenge product sales. Total direct costs increased by $5.4 million (167%) to $8.7 million for the year ended December 31, 2008. Depreciation of PokerPro systems increased by $674,337 (35%) to $2.6 million for the year ended December 31, 2008 as compared to $1.9 million for the year ended December 31, 2007. The increase in depreciation of PokerPro systems resulted from the growth in the balance of PokerPro systems as additional tables were leased in North American casinos during the year. Cost of product sales increased by $4.7 million (354%) to $6.1 million for the year ended December 31, 2008 as compared to $1.3 million for the year ended December 31, 2007. This increase in cost of sales is attributable to the 434% growth in product sales.
As a percentage of total revenues, direct cost of revenues improved to 60% of total revenues for the year ended December 31, 2008, compared with 81% of total revenues for the year ended December 31, 2007. The improvements were driven by the combination of increased sales of Heads-Up Challenge, which carried higher relative product margins than sales of the PokerPro system, and the increase in casino license and service fees. In addition, casino license fees increased at a faster rate than depreciation expense as we improved our utilization of leased PokerPro assets during the year.
Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) decreased by $247,598 (3%) to $9.0 million for the year ended December 31, 2008 as compared to $9.2 million for the year ended December 31, 2007. This decrease was primarily due to lower legal and professional fees and other operating expenses. The prior year included $263.087 for legal fees related to the Tellis lawsuit and there were no comparable settlement charges in the current year.
Cost reduction initiatives have significantly reduced the SG&A run rates on a quarterly basis since 2007, although relatively lower expenses during the first half of 2007 affect the year-over-year comparison. As a percentage of total revenues, SG&A expenses improved to 62% of total revenues for the year ended December 31, 2008, compared with 230% of total revenues for the year ended December 31, 2007.
Research and Development Expenses. Research and Development Expenses (“R&D”) decreased by $1.2 million (31%) to $2.8 million for the year ended December 31, 2008 as compared to $4.0 million for the year ended December 31, 2007. We continue to invest in software and hardware development to improve our gaming and amusement products through the addition of new games and features and to improve manufacturability. However, as our Heads-Up Challenge and PokerPro products are now fully commercialized, we have been able to reduce spending on pre-production engineering and internal development efforts.
Depreciation. Depreciation increased by $65,543 (45%) for the year ended December 31, 2008 to $210,260 from $144,717 for the year ended December 31, 2007.
Interest Income (Expense), net. Interest income (expense), net changed by $658,885 (117%) for the year ended December 31, 2008 to an expense of $94,285 from income of $564,600 for the year ended December 31, 2007. We incurred interest expense in 2008 on the loan from our founders, advances under the UBS Credit Facility, as well as origination and unused line fees associated with the credit line from Silicon Valley Bank.
In addition, we earned higher amounts of interest income during 2007 than we did in 2008 as our average invested balances were higher in 2007 and the interest rates earned on our auction rate securities (“ARS”) declined from an average of 5.4% during 2007 to 2.9% during 2008 as a result of deteriorating conditions in the credit markets and the disruptions in the ARS market.
Income Taxes. Income tax provision was $262,905 for the year ended December 31, 2008 and zero in the comparable period of 2007. The income tax provision is attributable to taxes incurred in Canada which cannot be recovered or offset against domestic net operating loss carryforwards.
Net Loss. Net loss for the year ended December 31, 2008 was $7.6 million, an improvement of $5.2 million (41%) from $12.8 million for the year ended December 31, 2007. Net loss per share, basic and diluted, was $0.70 per share for the year ended December 31, 2008, an improvement of $0.53 (43%) per share from $1.23 for the comparable period of 2007. Net loss and net loss per share improved over the prior year period due primarily to the combination of significantly higher revenues from the casino and amusement product lines and lower operating expenses, partially offset by higher direct cost of revenue.
Results of Operations for the Year Ended December 31, 2007 Compared to the Year Ended December 31, 2006 Revenue. Revenue increased by $2.0 million (102%) to $4.0 million for the year ended December 31, 2007 as compared to $2.0 million for the year ended December 31, 2006.
License and service fees increased by $1.7 million (203%) to $2.5 million for the year ended December 31, 2007 as compared to $823,986 for the year ended December 31, 2006. The increase in license and service fees was primarily due to an increase in the number of PokerPro systems deployed under product licensing agreements.
Product sales increased by $354,052 (31%) to $1.5 million for the year ended December 31, 2007 as compared to $1.2 million for the year ended December 31, 2006. Product sales consist primarily of PokerPro systems sold to Aristocrat for deployment in international casinos. Product sales also include $185,399 in revenues attributable to the launch of the Heads-Up Challenge product line, which was launched in late 2007 and had no revenues during the 2006 period.
Direct Cost of Revenue. Direct cost of revenue consists of depreciation of PokerPro systems and the cost of PokerPro systems sold primarily to Aristocrat and the cost of Heads-Up Challenge product sales. Total direct costs increased by $1.5 million (86%) to $3.2 million for the year ended December 31, 2007. Depreciation of PokerPro systems increased by $1.3 million (209%) to $1.9 million for the year ended December 31, 2007 as compared to $618,657 for the year ended December 31, 2006. The increase in depreciation of PokerPro systems resulted from the growth in the balance of PokerPro systems as additional tables were leased in North American casinos during the year. Cost of product sales increased by $210,046 (19%) to $1.3 million for the year ended December 31, 2007 as compared to $1.1 million for the year ended December 31, 2006. This increase in cost of sales is attributable to the 31% growth in product sales.
As a percentage of total revenues, direct cost of revenues improved to 81% of total revenues for the year ended December 31, 2007, compared with 88% of total revenues for the year ended December 31, 2006. The improvements were driven by the combination of the launch of sales of Heads-Up Challenge, which carried higher relative product margins than sales of the PokerPro system, and the increase in casino license and service fees.
Selling, General and Administrative Expenses. SG&A expenses increased by $3.5 million (62%) to $9.2 million for the year ended December 31, 2007 as compared to $5.7 million for the year ended December 31, 2006. This increase was primarily the result of an increase of $1.3 million related to the addition of personnel and infrastructure to support our growth strategy, an increase of $861,307 for legal and professional fees related to our regulatory and intellectual property efforts, $263,087 for legal fees related to the Tellis lawsuit, an increase in travel expenses of $346,121, an increase in licenses and permits of $144,580 and an increase in non-cash stock option expense of $123,451. During 2007, we established our North American sales team to market our products directly to casinos in North America and invested in intellectual property. These investments and others caused our SG&A to increase over the prior period, but also enabled us to more effectively grow market share while protecting our proprietary technology. As a percentage of total revenues, SG&A expenses improved to 230% of total revenues for the year ended December 31, 2007, compared with 286% of total revenues for the year ended December 31, 2006.
Research and Development Expenses. R&D increased by $447,193 (13%) to $4.0 million for the year ended December 31, 2007 as compared to $3.5 million for the year ended December 31, 2006. The increase was primarily the result of R&D activity related to developing the new Heads-Up Challenge product. We also continued to invest resources on further enhancements to the PokerPro system, including new games and other features to enhance the marketability and functionality of the product.
Depreciation. Depreciation increased by $53,781 (59%) for the year ended December 31, 2007 to $144,717 from $90,936 for the year ended December 31, 2006.
Interest Income, net. Interest income, net decreased by $176,161 (24%) for the year ended December 31, 2007 to $564,600 from $740,761 for the year ended December 31, 2006 primarily due to a lower average invested balance. The interest income principally relates to the interest earned from our investments.
Net Loss. Net loss for the year ended December 31, 2007 was $12.8 million, an increase of $3.7 million (40%) from $9.1 million for the year ended December 31, 2006. Net loss per share, basic and diluted, was $1.23 per share for the year ended December 31, 2007, an increase of $0.26 (27%) per share from $0.97 for the comparable period of 2006. Net loss and net loss per share increased over the prior year period due primarily to the higher cost of sales and operating expenses associated with the growth of the business.
Liquidity and Capital Resources
We have incurred net losses since inception as we continue to invest in growing our installed base of PokerPro systems and launching the Heads-Up Challenge amusement product.
Prior to 2008, we have historically funded our operating costs, research and development activities, working capital investments and capital expenditures associated with our growth strategy with proceeds from the issuances of our common stock. During 2008, we also began using debt as a means to finance our operations, including the credit facilities and loans described below.
Discussion of Statement of Cash Flows
For the year ended December 31, 2008, net cash used in operating activities improved $7.9 million (55%) to $6.5 million as compared to $14.4 million for the year ended December 31, 2007. The improvement in operating cash flows resulted from improvement in the company’s operating results as well as declines in the cash invested in working capital.
Net cash provided by investing activities increased $671,883 (54%) to $1.9 million for the year ended December 31, 2008, from $1.2 million for the year ended December 31, 2007. Cash provided by investing activities is primarily a function of investments and redemptions of our auction rate securities portfolio, and to a smaller degree, capital expenditures for assets used in our operations.
Net cash provided by financing activities was $4.9 million for the year ended December 31, 2008, compared to cash provided by financing activities of $12.6 million during the year ended December 31, 2007. During 2008, cash provided from financing activities consisted primarily of proceeds from our loan to our founders ($2 million), and net advances from the UBS line of credit ($2.9 million). During 2007, cash provided by financing activities was primarily attributable to $12.5 million received in connection with the private placement in April 2007.
Equity Offerings. We completed our initial public offering on October 13, 2005 by selling 2.25 million shares of common stock at $11.00 per share, including the partial exercise of the underwriter’s over-allotment option. The initial closing of the offering occurred on October 19, 2005 and we received proceeds of approximately $19.6 million, net of offering expenses and underwriting discounts. On November 29, 2005, the underwriter exercised its over-allotment option, resulting in the receipt of additional net proceeds of approximately $2.2 million.
On April 23, 2007, we entered into a Securities Purchase Agreement, pursuant to which we issued and sold an aggregate of 1,444,444 shares of our common stock in a private placement to certain investors for a purchase price of $9.00 per share. The private placement, which was completed on April 26, 2007, resulted in gross proceeds of approximately $13.0 million and net proceeds of approximately $12.5 million after fees and expenses associated with the private placement, including a cash placement agent fee.
Founders’ Loan. On March 24, 2008, we entered into a loan agreement with Lyle A. Berman, James T. Crawford III, Arthur Lee Lomax and Gehrig H. “Lou” White. Messrs. Crawford, Lomax and White are the founders of the Company. Each of the lenders are also members of our board of directors, with Mr. Berman serving as Chairman and Mr. White serving as Vice Chairman. Upon closing, the lenders loaned us $2.0 million and we issued the lenders a promissory note in the principal amount of $2.0 million. The loan bears interest at an annual rate of 13% with all unpaid principal and interest payable on March 24, 2010. We are paying and intend to continue to pay interest on a monthly basis. The loan principal may be repaid prior to maturity without penalty. The loan contains no restrictive covenants and is collateralized by a security interest in our PokerPro systems deployed in North America and on cruise ships as of December 31, 2007.
SVB Credit Facility: On July 25, 2008, we entered into a credit facility with Silicon Valley Bank to support our working capital (the “SVB Credit Facility”). The SVB Credit Facility is nominally denoted as a $5.0 million facility with an actual maximum availability that varies based on specified percentages of domestic and foreign accounts receivable and inventory. Based on our accounts receivable and inventory levels on December 31, 2008, as of such date availability under the SVB Credit Facility was approximately $1.6 million, with no borrowings outstanding. The SVB Credit Facility has a one-year term and bears interest at an annual rate of prime plus 2.0%. The SVB Credit Facility includes covenants requiring the achievement of specified financial ratios and thresholds and contains other terms and conditions customary for this type of credit facility.
UBS Credit Facility. On August 13, 2008, we entered into a Credit Line Agreement with UBS Bank USA for a demand revolving line of credit with respect to our ARS held in an account with UBS. Advances under the line of credit, to be made at the sole discretion of UBS Bank USA at up to 80% of the value of our ARS, bear interest at LIBOR plus 1.0%. This line of credit replaced a $1,000,000 loan made by UBS to us under the terms of a March 19, 2008 Client’s Agreement between us and UBS. At December 31, 2008, we had $3.9 million invested in ARS and $2.9 million in loans collateralized by those securities. At December 31, 2008 there was $2.9 million available under the credit line, of which $2.9 million of borrowings were outstanding.
On October 8, 2008, UBS offered us the right to sell our ARS at par value to UBS during a two-year period starting January 2, 2009. We formally accepted this offer on November 11, 2008. On January 5, 2009, subsequent to the end of 2008, we exercised our rights to put those ARS investments back to UBS at par value. We received net cash proceeds of $1.0 million after selling our $3.9 million ARS investment to UBS and liquidating our $2.9 million in advances under the UBS Credit Facility.
We no longer have any investments in ARS or debt with UBS following this transaction.
Operations and Liquidity Management. The level of additional cash needed to fund our operations is influenced primarily by the following factors, please see Item 1A, “Risk Factors” for discussion of other risks and uncertainties that may also impact our liquidity:
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The pace of growth in our casino business in the North American and cruise ship markets and the related investments we may need to make in inventory and PokerPro systems.
o
Growth in these markets require working capital as the expenditures required to manufacture and install PokerPro tables are generally incurred in advance of product placement, whereas revenues are generally earned over time on a monthly lease basis. The capital intensive nature of the PokerPro leasing business makes access to the capital markets an important component of managing and growing our business.
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The pace of growth in sales of our Heads-Up Challenge amusement product and the related investments we may make in inventory and purchase commitments.
o
The Heads-Up Challenge business model is less capital intensive than PokerPro, generally resulting in upfront product margins. However, due to long lead times associated with an international supply chain and in order to minimize manufacturing costs, we have entered into significant purchase commitments with our supplier requiring us to purchase inventory in future periods based on forecasts which may not match up with the timing of our product sales.
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Our ability to control our operating expenses and generate positive operating leverage as we grow.
o
We have reorganized our overhead structure and reduced our operating costs significantly between the third quarter of 2007 and the first quarter of 2009. Our ability to further streamline the organization and continue to reduce operating costs is not unlimited and we may need to hire additional personnel or otherwise increase our operating expenses as we grow.
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Our ability to negotiate favorable payment terms with our customers and vendors.
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The impact of the economy or other factors on our customers and suppliers, including the impact on demand for our products and our customers’ ability to pay us on a timely basis.
We have the ability to impact the timing and extent of our cash needs primarily by managing the pace of growth in both our PokerPro and Heads-Up-Challenge products and managing our operating expenses. However, we also have significant contractual obligations and our ability to control both the timing and extent of the cash needs of the business is not unlimited, particularly in light of the current economic climate and the capital intensive nature of the PokerPro business.
Our management’s strategy is to balance revenue growth with operating expense and working capital management, while carefully monitoring the impact of growth on our cash needs and cash balances. Accordingly, reductions in our working capital investments or declines in demand for our products or continued deterioration in general economic conditions could impact our ability to grow or to effectively manage our liquidity needs. If we are unable to execute our operating plan, manage our working capital effectively or are impacted by other events, we may need to attempt to raise additional funds through public or private offerings of our securities, additional credit facilities or other sources which may not be available on favorable terms, if at all. If such sources of capital are not available or not available on sufficiently favorable terms, we may seek other avenues to fund the business, including sale/leaseback arrangements, transitioning PokerPro from a capital intensive leasing strategy to a product sale strategy, or seeking to sell assets of all, or a portion of, our operations. If we decide to raise capital in the equity markets or take other actions, our shareholders could incur significant dilution or diminished valuations, or, if we are unable to raise capital, our ability to effectively operate our business could be impaired.
Impact of Inflation
To date, inflation has not had a material effect on our net sales, revenues or income from continuing operations.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Contractual Obligations
The table below sets forth our known contractual obligations as of December 31, 2008:
(1)
Represents the outstanding principal amount and interest on our Founder’s Loan and UBS Credit Facility.
(2)
Represents operating lease agreements for office and storage facilities and office equipment.
(3)
Represents outstanding principal and interest payable under capital lease obligations related to our purchase of internal-use ERP system.
(4)
Represents open purchase orders with our vendors, primarily purchase obligations for Heads-Up Challenge.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. On an ongoing basis, we evaluate these estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe that of our significant accounting policies, which are described in Note 1 - “Nature of Business and Significant Accounting Policies” to our consolidated financial statements appearing elsewhere in this report, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
Revenue recognition: We recognize revenue in accordance with Statement of Position No. 97-2 (“SOP 97-2”), Software Revenue Recognition (as amended by SOP No. 98-4 and SOP No. 98-9), and Staff Accounting Bulletin No. 101 (“SAB 101”), Revenue Recognition in Financial Statements, as updated by SAB 104, Revenue Recognition. If multiple product deliverables are included under a sale or license agreement, we allocate revenue to each product based upon their respective fair values in relation to the total contract value and defer revenue recognition on those deliverables that have not met all requirements of revenue recognition.
Revenues from product sales, including sales of the PokerPro system to Aristocrat International Pty. Limited (“Aristocrat”), our international distributor for PokerPro gaming products and a significant shareholder, are recognized when all of the following have occurred:
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Persuasive evidence of an arrangement exists;
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The fee is fixed or determinable;
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Delivery has occurred;
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Collectibility is reasonably assured; and
·
Title and risk of loss have passed to the customer.
In many cases, arrangements include recurring fees based on either a fixed monthly fee or a pre-determined percentage of the amount the casino or card club charges for each hand of poker (the “rake”). In some cases, we may also charge separately for installation, training and post contract customer support (“PCS”). Where we are responsible for performing initial installation and training, all revenue is deferred until such time as those services have been rendered. Following installation, we account for hardware, software license, PCS and other elements in accordance with SOP 97-2 and consistent with the guidance provided by the American Institute of Certified Public Accountants’ Technical Practice Aid 5100.76, Fair Value in Multiple-Element Arrangements That Include Contingent Usage-Based Fees and Software Revenue Recognition. License and service fees are recognized when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed and determinable and collectability is reasonably assured. This normally occurs on a monthly basis as the amounts contractually due are computed and invoiced, PCS is delivered and all other revenue recognition criteria are satisfied.
Investments in Auction Rate Securities (“ARS”): We account for auction rate securities in accordance with Statement of Financial Accounting Standards No. 115 (“FAS 115”), Accounting for Certain Investments in Debt and Equity Securities.
Research and development: Research and development costs are charged to expense when incurred and are included in the consolidated statements of operations, except when certain qualifying expenses are capitalized in accordance with Statement of Financial Accounting Standards No. 86 (“FAS 86”), Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. Capitalization of development costs of software products begins once the technological feasibility of the product is established. Capitalization ceases when such software is ready for general release, at which time amortization of the capitalized costs begins. As of December 31, 2008 and 2007, no amounts were capitalized as technological feasibility is generally established at or near the time of general release.
Inventories: Inventories are stated at the lower of cost or market, where cost is determined on a first-in, first-out basis. We include an allocation of direct labor, indirect labor and overhead for each PokerPro system. Costs not clearly related to the procurement, manufacture or implementation are expensed as incurred. Repairs, maintenance and rework are expensed as incurred.
PokerPro systems and property and equipment: PokerPro systems and property and equipment are stated at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful life of the asset. Estimated useful lives are generally three years for PokerPro systems and five years for equipment and office furniture. Leasehold improvements are amortized over the shorter of the term of the lease or the useful life of the improvement. Expenditures for maintenance and repairs are expensed as incurred.
Share-based compensation: We account for share-based compensation in accordance with Statement of Financial Accounting Standards No. 123R (“FAS 123R”), Share Based Payment, which was adopted effective January 1, 2006, replacing Statement of Financial Accounting Standards No. 123 (“FAS 123”), Accounting for Stock-Based Compensation and superseding APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees.”
Under FAS 123R, we value stock options issued based upon the Black-Scholes option pricing model and recognize the compensation over the period in which the options vest. There are inherent estimates made by management regarding the calculation of stock option expense, including volatility, expected life and forfeiture rate (see Note 10 - “Shareholders’ Equity - Stock Incentive Plan”).
As of the adoption of FAS 123R, we began recognizing compensation expense for options that vest over time using the straight-line attribution approach. For time-based options issued prior to the adoption of FAS 123R, we continue to use the graded attribution approach. For performance-based options issued to third parties, compensation expense is determined at each reporting date in accordance with the fair value method prescribed by the provisions of Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services ("EITF 96-18"). Until the measurement date is reached, the total amount of compensation expense remains uncertain. Compensation expense is recorded based on the fair value of the award at the reporting date and then revalued, or the total compensation is recalculated, based on the current fair value at each subsequent reporting date.
Recent Accounting Pronouncements
In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 161 (“FAS 161”), Disclosures about Derivative Instruments and Hedging Activities. FAS 161 improves financial reporting on derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. The new standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We do not currently hold any derivative instruments; thus, adoption of FAS 161 would not currently have any effect on our results of operations, financial condition, or cash flows.
In May 2008, the FASB issued Statement of Financial Accounting Standard No. 162, The Hierarchy of Generally Accepted Accounting Principles (“FAS 162”). FAS 162 identifies the sources of accounting principles and the framework for selecting principles to be used in the preparation of financial statements that are presented in conformity with U.S. GAAP. The U.S. GAAP hierarchy was previously set forth in the American Institute of Certified Public Accountants (“AICPA”) Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Though the FASB does not expect a change in current practice, the Board issued this statement in order for the U.S. GAAP hierarchy to reside in the accounting literature established by the FASB. FAS 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Any effect of applying the provisions of FAS 162 shall be reported as a change in accounting principle in accordance with Statement of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections. We do not expect FAS 162 to have a material impact on our financial statements.
In June 2008, the FASB issued FSP No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). The FASB concluded in this FSP that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and shall be included in the calculation of earnings per share pursuant to the two-class method. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, requiring all prior-period earnings per share data presented to be adjusted retrospectively. We do not expect FSP EITF 03-6-1 to have a material impact on our calculation of earnings per share.
In June 2008, the FASB issued EITF 07-05, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock, (“EITF 07-05”). EITF 07-05 provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in paragraph 11(a) of SFAS 133. EITF 07-05 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and early application is not permitted if an entity has previously adopted an alternative policy. We are currently evaluating the effect, if any, of EITF 07-05 on our financial statements.
In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 (“FAS 160”), Noncontrolling Interest in Consolidated Financial Statements - an amendment of ARB No. 51. FAS 160 changes reporting standards for noncontrolling interests in a subsidiary. The standard is effective for fiscal years beginning on or after December 15, 2008. We do not expect the adoption of FAS No. 160 to have a material impact on our results of operations, financial condition, or cash flows.
In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Liabilities (“FAS 159”). FAS 159 provides entities with the option to report selected financial assets and liabilities at fair value. Business entities adopting FAS 159 will report unrealized gains and losses in earnings at each subsequent reporting date on items for which the fair value option has been elected. We elected the fair value option for our ARS investments as of December 31, 2008 (See Note 2, Investments in Auction Rate Securities (“ARS”)).
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
We are exposed to market risks from both changes in interest rates and foreign exchange rates. A discussion of our primary market risks is presented below:
Cash and investments. Our cash and cash equivalents are not subject to significant interest rate risk due to the short maturities of these instruments. As of December 31, 2008, the carrying value of our cash and cash equivalents approximated fair value.
Our investments in ARS are subject to significant market and interest rate risk due to the failure of the auction process to provide liquidity and due to the long term maturities of the underlying investment securities. In addition to our investment in ARS, as of December 31, 2008, we also held a Rights Option issued by UBS Financial Services, giving us the right to put the ARS investments back to UBS at par for a specified period of time beginning on January 2, 2009. As of December 31, 2008, the estimated fair value of the Investment in ARS was $3.3 million and our cost basis was $3.9 million. As of December 31, 2008, the estimated fair value of the Rights Option was $0.6 million and our cost basis was zero.
On January 5, 2009, subsequent to the end of 2008, we exercised our rights to put those ARS investments back to UBS at par value. We received net cash proceeds of $1.0 million after selling our $3.9 million ARS investment to UBS and liquidating our $2.9 million in advances under the UBS Credit Facility. We no longer have any investments in ARS or debt with UBS following this transaction
We do not use derivative financial instruments for speculation, or trading purposes.
Fixed rate debt. Our founders’ loan bears interest at a fixed annually rate of 13%. As market interest rates fluctuate, the fair value of our founders’ debt will also fluctuate. The estimated fair value of our founders’ loan as of December 31, 2008 was $1.9 million. We estimate a 10% increase in interest rates would decrease the fair value by approximately $0.1 million. These changes would impact the fair value disclosures for this financial instrument, but would have no impact on interest expense paid or recognized in the consolidated statement of operations as the loan bears a fixed interest rate.
Variable rate debt. Our UBS Credit Facility and SVB Credit Facility both bear interest at variable rates, based on spreads over LIBOR and Prime, respectively. As of December 31, 2008, we had approximately $2.9 million of variable rate debt outstanding under the UBS Credit Facility and nothing drawn under the SVB Credit Facility. A change in average interest rates would not have had a significant effect on net interest expense during 2008, as there were no balances outstanding under the SVB Credit Facility and any change in interest rates impacting the UBS Credit Facility would be largely offset by changes to interest income received on the ARS investments. As of December 31, 2008, the carrying value of our variable rate debt instruments approximated fair value.
On January 5, 2009, subsequent to the end of 2008, we exercised our rights to put those ARS investments back to UBS at par value. We received net cash proceeds of $1.0 million after selling our $3.9 million ARS investment to UBS and liquidating our $2.9 million in advances under the UBS Credit Facility. We no longer have any investments in ARS or debt with UBS following this transaction.
Foreign currency risk. Our revenues from international customers and our inventory costs from international suppliers are exposed to the potentially adverse effects of currency exchange rates, local economic conditions, political instability and other risks associated with doing business in foreign countries. To the extent that our revenues and purchases from international business partners increase in the future, our exposure to changes in foreign economic conditions and currency fluctuations will increase.
Our dependence on foreign customers and suppliers means, in part, that we are affected by changes in the relative value of the U.S. dollar to foreign currencies, particularly the British pound, Euro Canadian dollar and Taiwan dollar. Although our receipts from foreign customers and our purchases of foreign products are principally negotiated and paid for in U.S. dollars, changes in the applicable currency exchange rates might negatively affect the profitability and business prospects of our customers and vendors. This, in turn, might cause such vendors to demand higher prices, delay shipments, or discontinue selling to us. This also might cause such customers to demand lower prices, delay or discontinue purchases of our products or demand other changes to the terms of our relationships. These situations could in turn ultimately reduce our revenues or increase our costs, which could have a material adverse effect on our business, financial condition or results of operations.
We do not use derivative financial instruments for speculation, or trading purposes, or engage in any other hedging strategies with regard to our foreign currency risk.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The information required by this Item is submitted as a separate section of this Annual Report commencing on page attached hereto.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A
Item 9A (T). Controls and Procedures.
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act), which are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
As of December 31, 2008, an evaluation of the effectiveness of the Company’s disclosure controls and procedures was conducted under the supervision of, and reviewed by, the Company’s Chief Executive Officer and Chief Financial Officer. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2008, to enable us to record, process, summarize and report in a timely manner the information that we are required to disclose in our Exchange Act reports, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of the Company’s consolidated financial statements in accordance with accounting principles generally accepted in the United States.
The Company’s internal control over financial reporting includes those policies and procedures that:
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pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
·
provide reasonable assurance that transactions are recorded properly to allow for the preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company;
·
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements; and
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provide reasonable assurance as to the detection of fraud.
All internal controls, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can only provide reasonable assurance with respect to financial statement preparation and presentation and may not prevent or detect misstatements.
Our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework and in accordance with the interpretive guidance issued by the SEC in Release No. 34-55929. Based on that evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2008.
During the course of management’s assessment, our management identified the following significant deficiencies in our internal control over financial reporting which had been identified as of December 31, 2007 and had not been fully remediated as of December 31, 2008:
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The systems used in tracking and valuing inventory and PokerPro systems do not provide effective automated controls and are not integrated with each other or with the general ledger. The lack of integration requires manual reconciliations between the applications.
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The Company utilized a software package for its general ledger that did not provide certain automated general controls, such as the presence of edit reports and workflow approvals. The Company replaced its general ledger and other financial systems during the fourth quarter of 2008, however the new system was not functioning for a sufficient period of time to affect management’s assessment of the effectiveness of internal control over financial reporting.
In addition, the following new significant deficiencies in our internal control over financial reporting have been identified and have not been fully remediated as of December 31, 2008:
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The Company’s procedures for establishing and modifying system user access privileges was not sufficiently documented and subjected to management review to ensure that only authorized users have access to the Company’s sensitive applications, and that those authorized users only have access to appropriate functions within those systems.
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Due to the relatively small size of the finance department, the Company lacked an effective segregation of duties between the disbursement of funds and the reconciliation of its bank accounts.
All identified deficiencies, including the significant deficiencies listed above, were reported to the Company’s Audit Committee by our management and to our independent registered public accounting firm.
We are currently implementing a new enterprise resource planning (“ERP”) system, including integrated inventory and fixed asset applications to further strengthen our internal controls. During the fourth quarter of 2008, the finance modules of that ERP system were successfully implemented, including general ledger, accounts receivable and accounts payable. We are currently finalizing the application configuration, documentation and testing phases required to implement the remaining modules of the integrated ERP system. In connection with the new system implementation, management also plans to formalize its user access procedures and improve the documentation and management review to ensure proper access. We have also separated responsibility for bank reconciliations from the accounts payable function. However, we can provide no assurance that a new ERP system will be fully deployed or that the implementation of new systems and other procedures will fully resolve all significant deficiencies or that we will not create or discover additional significant deficiencies during that transition.
Compensating controls, including more timely reconciliations, enhanced review and approval procedures, as well as more robust physical inventory counting and valuation procedures were implemented in the fourth quarter of 2007 and continued to be performed throughout 2008 as the new ERP system was being developed and readied for deployment. Although the process of establishing and maintaining user access levels for our overall systems lacked adequate formal documentation, we carefully reviewed access to our general ledger, accounts payable and accounts receivable system in connection with the implementation of the new ERP system to ensure that user access was appropriate for those sensitive applications. In addition, we changed responsibility for the preparation of bank reconciliations during the fourth quarter of 2008. Accordingly, our management believes that these significant deficiencies are not indicative of a material weakness in internal control over financial reporting and thus, as noted above, our management concluded that, as of December 31, 2008, our internal control over financial reporting was effective.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control over Financial Reporting
During the fourth quarter ended December 31, 2008, our management completed the implementation of the finance modules of the Company’s new ERP system, with the remaining modules expected to be implemented during 2009, as discussed in “Management’s Report on Internal Control over Financial Reporting.” There were no other changes in internal control over financial reporting during the quarter ended December 31, 2008 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Information called for by this item may be found in our definitive Proxy Statement in connection with our 2009 Annual Meeting of Shareholders to be filed with the SEC under the headings “Board of Directors and Management,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance Matters” and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
Information called for by this item may be found in our definitive Proxy Statement in connection with our 2009 Annual Meeting of Shareholders to be filed with the SEC under the headings “Executive Compensation” and “Corporate Governance Matters” and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information called for by this item may be found in our definitive Proxy Statement in connection with our 2009 Annual Meeting of Shareholders to be filed with the SEC under the headings “Equity Compensation Plan Information” and “Security Ownership of Certain Beneficial Owners and Management” and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Information called for by this item may be found in our definitive Proxy Statement in connection with our 2009 Annual Meeting of Shareholders to be filed with the SEC under the headings “Related Person Transactions” and “Corporate Governance Matters” and is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
Information called for by this item may be found in our definitive Proxy Statement in connection with our 2009 Annual Meeting of Shareholders to be filed with the SEC under the headings “Independent Registered Public Accounting Firm Fee Information” and “Audit Committee Pre-Approval Policy” and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a) The following documents are filed as a part of this Form 10-K:
1. Financial Statements
The following financial statements are included in a separate section of this Annual Report on Form 10-K beginning on page:
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Report of Independent Registered Public Accounting Firm;
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Consolidated Statements of Operations for the years ended December 31, 2008, December 31, 2007 and December 31, 2006;
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Consolidated Balance Sheets as of December 31, 2008 and December 31, 2007;
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Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2008, December 31, 2007 and December 31, 2006;
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Consolidated Statements of Cash Flows for the years ended December 31, 2008, December 31, 2007 and December 31, 2006; and
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Notes to Consolidated Financial Statements.
2. Financial Statement Schedules
The following financial statement schedule is included in a separate section of this Annual Report on page S-1:
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Valuation and Qualifying Accounts and Reserves
Other financial statement schedules are omitted because they are not required or are not applicable, or the required information is provided in the consolidated financial statements or notes described in Item 15(a)(1) above.
3. Exhibits
The Exhibits listed in the Exhibit Index, which appears immediately following the Financial Statement Schedules and is incorporated herein by reference, are filed as part of this Annual Report on Form 10-K.
(b) See the Exhibit Index.
(c) Separate Financial Statements and Schedules
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
PokerTek, Inc.
Matthews, North Carolina
We have audited the accompanying consolidated balance sheets of PokerTek, Inc. and Subsidiary (together, “PokerTek” or the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules of PokerTek, Inc. listed in Item 15(a). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 PokerTek as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We were not engaged to examine management's assessment of the effectiveness of PokerTek’s internal control over financial reporting as of December 31, 2008, included in the accompanying “Management’s Report on Internal Control over Financial Reporting” and, accordingly, we do not express an opinion thereon.
/s/ McGladrey & Pullen, LLP
Charlotte, North Carolina
March 31,
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POKERTEK, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
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The accompanying notes are an integral part of these consolidated financial statements.
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The accompanying notes are an integral part of these consolidated financial statements.
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The accompanying notes are an integral part of these consolidated financial statements.
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POKERTEK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2008
Note 1. Nature of Business and Significant Accounting Policies
Nature of Business
PokerTek, Inc. (“PokerTek” or the “Company”) is engaged in the development, manufacture and marketing of electronic poker-related products for use in the gaming and amusement markets.
The Company currently has two product lines, PokerPro® gaming products and Heads-Up Challenge™ amusement products.
The PokerPro system consists of electronic poker table(s) and related peripheral equipment providing commercial casinos, tribal casinos, cruise ships and card clubs with a fully-automated poker-room environment designed to improve the profitability of poker by enhancing the operator’s revenue opportunities and decreasing their startup and operating costs. Heads-Up Challenge is an innovative amusement platform that enables two players to compete head to head against each other for entertainment purposes in non-gambling venues such as bars and restaurants.
Basis of Presentation and Principles of Consolidation
These consolidated financial statements include the accounts of PokerTek, Inc. and its consolidated subsidiary. They have been prepared by the Company in accordance with accounting principles generally accepted in the United States. The financial statements of the Company’s foreign subsidiary are measured using the U.S. dollar as the functional currency. All significant intercompany transactions and accounts have been eliminated in consolidation.
Significant Accounting Policies
Accounting estimates: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue recognition: The Company recognizes revenue in accordance with Statement of Position No. 97-2 (“SOP 97-2”), Software Revenue Recognition (as amended by SOP No. 98-4 and SOP No. 98-9), and Staff Accounting Bulletin No. 101 (“SAB 101”), Revenue Recognition in Financial Statements, as updated by SAB 104, Revenue Recognition. If multiple product deliverables are included under a sale or license agreement, the Company allocates revenue to each product based upon their respective fair values in relation to the total contract value and defers revenue recognition on those deliverables that have not met all requirements of revenue recognition.
Revenues from product sales, including sales of casino products to Aristocrat International Pty. Limited (“Aristocrat”), the Company’s international distributor for PokerPro gaming products and a significant shareholder, are recognized when all of the following have occurred:
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Persuasive evidence of an arrangement exists;
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The fee is fixed or determinable;
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Delivery has occurred;
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Collectibility is reasonably assured; and
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Title and risk of loss have passed to the customer.
In many cases, arrangements include recurring fees based on either a fixed monthly fee or a pre-determined percentage of the amount the casino or card club charges for each hand of poker (the “rake”). In some cases, the Company may also charge separately for installation, training and post contract customer support (“PCS”). Where the Company is responsible for performing initial installation and training, all revenue is deferred until such time as those services have been rendered. Following installation, the Company accounts for hardware, software license, PCS and other elements in accordance with SOP 97-2 and consistent with the guidance provided by the American Institute of Certified Public Accountants’ Technical Practice Aid 5100.76, Fair Value in Multiple-Element Arrangements That Include Contingent Usage-Based Fees and Software Revenue Recognition. License and service fees are recognized when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed and determinable and collectability is reasonably assured. This normally occurs on a monthly basis as the amounts contractually due are computed and invoiced, PCS is delivered and all other revenue recognition criteria are satisfied.
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Cash and cash equivalents: The Company considers all cash accounts and highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
Investments in Auction Rate Securities (“ARS”): The Company accounts for its auction rate securities in accordance with Statement of Financial Accounting Standards No. 115 (“FAS 115”), Accounting for Certain Investments in Debt and Equity Securities.
Concentrations of credit risk: Financial instruments that subject the Company to credit risk primarily consist of cash and cash equivalents, marketable securities and accounts receivables. The Company’s credit risk is managed by investing primarily in high-quality money market instruments and securities guaranteed by the U.S. government and its agencies.
Receivables and allowance for doubtful accounts: The Company monitors its exposure for credit losses on its customer receivable balances and the credit worthiness of its customers on an ongoing basis and records related allowances for doubtful accounts. Allowances are estimated based upon specific customer balances, where a risk of default has been identified, and also include a provision for non-customer specific defaults based upon historical experience. As of December 31, 2008 and December 31, 2007, the Company recorded reserves of $81,403 and $21,062, respectively. If circumstances related to specific customers change, estimates of the recoverability of receivables could also change.
Deferred licensing fees: Deferred licensing fees consist of amounts paid to various regulatory agencies. As approvals are obtained, the Company begins expensing the fees over the estimated term of the license. Deferred licensing fees are included in other assets on the consolidated balance sheets.
Patents. Legal fees and application costs related to the Company’s patent application process are expensed. There is a high degree of uncertainty in the outcome of approval for any of the Company’s patents.
Research and development: Research and development costs are charged to expense when incurred and are included in the consolidated statements of operations, except when certain qualifying expenses are capitalized in accordance with Statement of Financial Accounting Standards No. 86 (“FAS 86”), Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. Capitalization of development costs of software products begins once the technological feasibility of the product is established. Research and development costs include salaries, benefits, travel and other internal costs allocated to software and hardware development efforts, as well as purchased components, engineering services and other third party costs. Capitalization ceases when such software is ready for general release, at which time amortization of the capitalized costs begins. As of December 31, 2008 and 2007, no amounts were capitalized as technological feasibility is generally established at or near the time of general release.
Advertising: Advertising and promotional costs are expensed as incurred. Advertising costs for the years ended December 31, 2008, 2007 and 2006 were $41,859, $129,625 and $143,918, respectively.
Inventories: Inventories are stated at the lower of cost or market, where cost is determined on a first-in, first-out basis. The Company includes an allocation of direct labor, indirect labor and overhead for each PokerPro system. Costs not clearly related to the procurement, manufacture and implementation are expensed as incurred. We regularly review inventory for slow moving, obsolete and excess characteristics and evaluate whether inventory is stated at the lower of cost or net realizable value.
PokerPro systems and property and equipment: PokerPro systems represent equipment owned by PokerTek. The majority of this equipment is operated at customer sites pursuant to contractual license agreements. PokerPro systems may also include temporarily idle equipment returned from customer locations and equipment used by the Company for demonstration or testing purposes.
PokerPro systems are transferred from the Company’s inventory account to the PokerPro systems account at the time the units are fully assembled, configured, tested and otherwise ready for use by a customer. Because the configuration of each PokerPro system is unique to the specific customer environment in which it is being placed, the final steps to configure and test the unit generally occur immediately prior to shipment. Depreciation expense for PokerPro systems begins in the month of transfer of each PokerPro system from the Company’s inventory account to the PokerPro systems account.
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PokerPro systems and property and equipment are stated at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful life of the asset. Estimated useful lives are generally three years for PokerPro systems and five years for equipment and office furniture. Leasehold improvements are amortized over the shorter of the term of the lease or the useful life of the improvement. Expenditures for maintenance and repairs are expensed as incurred.
The Company reviews its property and equipment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 requires the Company to evaluate property and equipment as an event occurs or circumstances change that would more likely than not reduce the fair value of the property and equipment below the carrying amount. If the carrying amount of property and equipment is not recoverable from its undiscounted cash flows, then the Company would recognize an impairment loss for the difference between the carrying amount and the current fair value. Further, the Company evaluates the remaining useful lives of property and equipment at each reporting period to determine whether events and circumstances warrant a revision to the remaining depreciation periods.
Offering costs: Offering costs incurred in connection with the Company’s equity offerings, consisting principally of legal, accounting and underwriting fees, have been charged to additional paid in capital. As of December 31, 2008, approximately $3.2 million of offering costs, on a cumulative basis, has been incurred.
Income taxes: The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (“FAS 109”), Accounting for Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. 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 the period that includes the enactment date.
The Company has also adopted FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 as of January 1, 2007.
The accounting for income taxes involves significant judgments and estimates and deals with complex tax regulations. The recoverability of certain deferred tax assets is based in part on estimates of future income and the timing of temporary differences (see Note 11 - “Income Taxes”).
Earnings (loss) per share: The Company computes earnings (loss) per share in accordance with Statement of Financial Accounting Standards No. 128 (“FAS 128”), Earnings per Share. FAS 128 requires presentation of both basic and diluted earnings per share (“EPS”) on the face of the statement of operations. Basic EPS is computed by dividing net income (loss) available to common shareholders by the weighted-average number of shares outstanding during the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted to common stock. In computing Diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Diluted EPS excludes all potential dilutive shares due to their anti-dilutive effect.
Share-based compensation: The Company accounts for share-based compensation in accordance with Statement of Financial Accounting Standards No. 123R (“FAS 123R”), Share Based Payment, which was adopted effective January 1, 2006, replacing Statement of Financial Accounting Standards No. 123 (“FAS 123”), Accounting for Stock-Based Compensation and superseding APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees .”
Under FAS 123R, the Company values its stock options issued based upon the Black-Scholes option pricing model and recognizes the compensation over the period in which the options vest. There are inherent estimates made by management regarding the calculation of stock option expense, including volatility, expected life and forfeiture rate (see Note 10 - “Shareholders’ Equity - Stock Incentive Plan”).
As of the adoption of FAS 123R, the Company began recognizing compensation expense for options that vest over time using the straight-line attribution approach. For time-based options issued prior to the adoption of FAS 123R, the Company continues to use the graded attribution approach. For performance based options issued to third parties, compensation expense is determined at each reporting date in accordance with the fair value method prescribed by the provisions of Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”). Until the measurement date is reached, the total amount of compensation expense remains uncertain. Compensation expense is recorded based on the fair value of the award at the reporting date and then revalued, or the total compensation is recalculated, based on the current fair value at each subsequent reporting date.
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Warrants: The Company evaluates its outstanding warrants at issuance and at each quarter-end using the guidance set forth in Emerging Issues Task Force (“EITF”) No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF No. 00-19”). In evaluating the classification of the warrants under EITF 00-19 and the related registration rights, the Company also considers the guidance of Financial Accounting Standards Board (“FASB”) Staff Position No. 00-19-02, “Accounting for Registration Payment Arrangements.”
As a result of its evaluation and analysis, management determined that its warrants should be classified as equity instruments in the accompanying consolidated balance sheets.
Fair Value of Financial Instruments. On January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), for its financial assets and liabilities. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” SFAS No. 157 further defines a fair value hierarchy for measurement and disclosure of the fair value for financial instruments, as follows: Level 1 inputs as quoted prices in active markets for identical assets or liabilities; Level 2 inputs as observable inputs other than Level 1 prices, such as quoted market prices for similar assets or liabilities or other inputs that are observable or can be corroborated by market data; and Level 3 inputs as unobservable inputs that are supported by little or no market activity and that are financial instruments whose value is determined using pricing models or instruments for which the determination of fair value requires significant management judgment or estimation.
On October 10, 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. FSP 157-3 amended FAS 157 by providing an illustrative example to demonstrate how fair value should be determined when the market for that financial asset is not active. The adoption of FSP 157-3 did not have any effect on the Company’s results of operations, financial condition, or cash flows.
The fair value of financial assets and liabilities is determined at each balance sheet date and future declines in market conditions, the future performance of the underlying investments or new information could affect the recorded values of the Company’s investments.
Reclassifications: Certain reclassifications of previously reported balances have been made to conform with the current presentation. These reclassifications primarily relate to the presentation of depreciation and share-based compensation expense on the accompanying consolidated statements of operations. Such reclassifications had no impact on previously reported net loss or shareholders’ equity.
Recent Accounting Pronouncements
In March 2008, the FASB issued Statement of Financial Accounting Standard No. 161 (“FAS 161”), Disclosures about Derivative Instruments and Hedging Activities. FAS 161 improves financial reporting on derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. The new standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company is not currently the holder of any derivative instruments; thus, adoption of FAS 161 would not currently have any effect on the Company's results of operations, financial condition, or cash flows.
In May 2008, the FASB issued Statement of Financial Accounting Standard No. 162, The Hierarchy of Generally Accepted Accounting Principles (“FAS 162”). FAS 162 identifies the sources of accounting principles and the framework for selecting principles to be used in the preparation of financial statements that are presented in conformity with U.S. GAAP. The U.S. GAAP hierarchy was previously set forth in the American Institute of Certified Public Accountants (“AICPA”) Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Though the FASB does not expect a change in current practice, the Board issued this statement in order for the U.S. GAAP hierarchy to reside in the accounting literature established by the FASB. FAS 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Any effect of applying the provisions of FAS 162 shall be reported as a change in accounting principle in accordance with Statement of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections. The Company does not expect FAS 162 to have a material impact on its financial statements.
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In June 2008, the FASB issued FSP No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). The FASB concluded in this FSP that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and shall be included in the calculation of earnings per share pursuant to the two-class method. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, requiring all prior-period earnings per share data presented to be adjusted retrospectively. The Company does not expect FSP EITF 03-6-1 to have a material impact on its calculation of earnings per share.
In June 2008, the FASB issued EITF 07-05, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock, (“EITF 07-05”). EITF 07-05 provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in paragraph 11(a) of SFAS 133. EITF 07-05 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and early application is not permitted if an entity has previously adopted an alternative policy. The Company is currently evaluating the effect, if any, of EITF 07-05 on our financial statements.
In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 (“FAS 160”), Noncontrolling Interest in Consolidated Financial Statements - an amendment of ARB No. 51. FAS 160 changes reporting standards for noncontrolling interests in a subsidiary. The standard is effective for fiscal years beginning on or after December 15, 2008. The Company does not expect the adoption of FAS No. 160 to have a material impact on the Company's results of operations, financial condition, or cash flows.
In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Liabilities (“FAS 159”). FAS 159 provides entities with the option to report selected financial assets and liabilities at fair value. Business entities adopting FAS 159 will report unrealized gains and losses in earnings at each subsequent reporting date on items for which the fair value option has been elected. The Company elected the fair value option for its ARS investments as of December 31, 2008 (See Note 2, Investments in Auction Rate Securities (“ARS”).
Note 2. Investments in Auction Rate Securities (“ARS”)
The Company has historically invested its excess cash in ARS, which are interests in collateralized debt obligations supported by pools of federally backed student loans. Consistent with the Company’s investment policy, the ARS investments held by the Company all have AAA/Aaa credit ratings and are backed by The Federal Family Education Loan Program. The investments are securities with long-term nominal maturities for which the interest rates were previously reset through monthly dutch auctions. These auctions also served to provide a short-term liquid market for these investments until early 2008, when the Company’s ARS investments began to experience failed auctions.
As of December 31, 2008, the Company also held a Rights Option issued by UBS Financial Services, giving the Company the right to put the ARS investments back to UBS at par for a specified period of time beginning on January 2, 2009 (see Note 16, Subsequent Events).
As of December 31, 2008, the Company’s investments in ARS were required to be measured at fair value on a recurring basis in accordance with FAS 157. In addition, the Company utilized the guidance set forth in FSP 157-3 in evaluating fair value. FSP 157-3 clarified that a fair value measurement should not be based on a distressed sale or forced liquidation, but instead contemplates an orderly transaction between market participants even if there is little or no market activity for the asset at the measurement date. In evaluating the fair value of its ARS, Company management reviewed estimates of fair value prepared by its broker-dealer based on their proprietary valuation models and management also prepared its own calculations of fair value based on current interest rates and the estimated term of the investments underlying its ARS investment. Management evaluated the key assumptions being used by the broker-dealer in its model, as well as other pieces of information available, including, but not limited to, factors such as tax status, credit quality, duration, the portfolio composition of The Federal Family Education Loan Program loans, market interest rates, distressed transactions observed in secondary markets, and current status of the specific ARS investments. Both the broker-dealer’s estimates and management’s calculation were prepared using level 3 inputs.
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The Company also accounted for the Rights Option at fair value, using the fair value option available under FAS 159. Because the Rights Option provided the Company with the unilateral opportunity to put the ARS back to UBS at par immediately following year-end, the intrinsic value of the Rights Option was determined to be equal to the difference in the fair value of the ARS and the par value of the ARS. The ARS and the Rights Option are presented in the caption “Investments’” in the accompanying consolidated balance sheets.
The Company's assets measured at fair value on a recurring basis subject to the disclosure requirements of FAS 157 at December 31, 2008, were as follows:
The following table presents information about the Company's financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in FAS 157:
Note 3. Inventory
Inventory at December 31, 2008 and 2007 consist of the following:
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Note 4. Prepaid Expenses and Other Assets
Prepaid expenses and other assets at December 31, 2008 and 2007 consist of the following:
Note 5. PokerPro Systems
PokerPro systems at December 31, 2008 and 2007 consist of the following:
(a) The systems will be redeployed as scheduling allows. Included in the December 31, 2008 and December 31, 2007 accumulated depreciation is $272,799 and $206,178, respectively, related to the temporarily idle PokerPro systems.
Note 6. Property and Equipment
Property and equipment at December 31, 2008 and 2007 consist of the following:
Capitalized software consists of purchased software, consulting and capitalized internal costs related to the purchase and implementation of a new internal-use enterprise resource management system. Accumulated depreciation on capitalized software at December 31, 2008 was $8,668. The software portion of this systems investment was financed through a capital lease obligation (see Note 8, Debt).
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Note 7. Accrued Liabilities
Accrued liabilities at December 31, 2008 and 2007 consist of the following:
Note 8. Debt
The Company’s outstanding debt balances as of December 31, 2008 and December 31, 2007 consist of the following:
SVB Credit Facility: On July 25, 2008, the Company entered into a credit facility with Silicon Valley Bank to support the Company’s working capital (the “SVB Credit Facility”). The SVB Credit Facility is nominally denoted as a $5.0 million facility with an actual maximum availability that varies based on specified percentages of domestic and foreign accounts receivable and inventory. Based on the Company’s accounts receivable and inventory levels on December 31, 2008, as of such date availability under the SVB Credit Facility was approximately $1.6 million, with no borrowings outstanding. The SVB Credit Facility has a one-year term and bears interest at an annual rate of prime plus 2.0%. The SVB Credit Facility includes covenants requiring the achievement of specified financial ratios and thresholds and contains other terms and conditions customary for this type of credit facility. As of December 31, 2008, the Company was in compliance with these covenants. The SVB Credit Facility is collateralized by security interests in substantially all of the assets of the Company, except for the Company's investments in ARS.
UBS Credit Facility: On August 13, 2008, the Company entered into a Credit Line Agreement (the “Line of Credit”) with UBS Bank USA for a demand revolving line of credit with respect to the Company’s ARS held in an account with UBS. Advances under the Line of Credit, to be made at the sole discretion of UBS Bank USA at up to 80% of the value of the Company’s ARS, bear interest at LIBOR plus 1%. At December 31, 2008 there was approximately $2.9 million available under the Line of Credit, of which $2.9 million of borrowings were outstanding. The Line of Credit replaced the $1,000,000 loan made by UBS to the Company under the terms of a March 19, 2008 Client’s Agreement between the Company and UBS. The UBS Credit Facility is collateralized by the Company's investments in ARS.
As of December 31, 2008, the carrying value of the UBS Credit Facility approximated its fair value.
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Founders’ Loan: On March 24, 2008, the Company entered into a loan agreement with Lyle A. Berman, James T. Crawford III, Arthur Lee Lomax and Gehrig H. “Lou” White. Messrs. Crawford, Lomax and White are the founders of the Company. Each of the lenders are also members of our board of directors, with Mr. Berman serving as Chairman and Mr. White serving as Vice Chairman. Upon closing, the lenders loaned the Company $2.0 million and the Company issued the lenders a promissory note in the principal amount of $2.0 million. The loan bears interest at 13% with all unpaid principal and interest payable on March 24, 2010. The Company intends to pay interest on a monthly basis and the loan may be repaid prior to maturity without penalty. The loan contains no restrictive covenants and is collateralized by security interests in the Company’s PokerPro systems deployed in North America and on cruise ships as of December 31, 2007.
As of December 31, 2008, the carrying value of the Founders’ Loan was $2.0 million and its fair value was approximately $1.9 million.
Capital Lease Obligation: During 2008, the Company entered into capital lease obligations totaling $73,273 to finance the purchase of a new internal-use ERP system. These capital lease obligations bear interest at an annual rate of 9.4% and have a term of 36 months, resulting in monthly payments of $2,396. At the end of the lease term, the Company has the option to purchase the software for $101.
Note 9. Employee Benefit Plan
The Company has established a salary deferral plan under Section 401(k) of the Internal Revenue Code covering substantially all employees. The plan allows eligible employees to defer 3% to 5% of their annual compensation. The Company matches the contributions equal to 100% on the first 3% of the deferral and 50% on the deferral from 3% to 5%. For the years ended December 31, 2008, 2007 and 2006 the Company’s contributions were $134,478, $110,473 and $49,150, respectively.
Note 10. Shareholders’ Equity
Common and Preferred Stock
Common Stock: There are 100,000,000 authorized shares of the Company’s common stock of which 11,021,429 and 10,934,464 were outstanding as of December 31, 2008 and December 31, 2007, respectively.
On April 23, 2007, the Company entered into a Securities Purchase Agreement, pursuant to which the Company issued and sold an aggregate of 1,444,444 shares of common stock in a private placement to certain investors for a purchase price of $9.00 per share. The private placement, which was completed on April 26, 2007, resulted in gross proceeds of approximately $13.0 million and net proceeds of approximately $12.5 million after fees and expenses associated with the private placement including a cash placement agent fee.
Preferred Stock: There are 5,000,000 authorized shares of preferred stock, none of which are outstanding as of December 31, 2008 and December 31, 2007.
Warrants
As part of the initial public offering, the Company issued to the underwriter, for a purchase price of $50.00, a warrant (the “Underwriter’s Warrant”) to purchase up to 200,000 shares of common stock. The Underwriter’s Warrant is exercisable at a price of $17.60 per share for a period of four years. The Underwriter’s Warrant contains customary anti-dilution provisions and certain demand and participatory registration rights. The Underwriter’s Warrant also includes a “cashless” exercise provision entitling the Underwriter to convert the Underwriter’s Warrant into shares of the Company’s common stock. The fair value of the Underwriter’s Warrant was computed at the time of issue and was nominal.
As part of the April 2007 private placement, the Company issued each Investor a warrant (the “Warrants”) to acquire additional shares of the Company’s common stock (together, the “Warrant Shares”). The Warrants, which expire on April 26, 2012, were convertible into an aggregate of 505,555 Warrant Shares at an exercise price of $10.80 per Warrant Share. The Warrants contain customary anti-dilution provisions and certain demand and participatory registration rights. The Warrants also include a “cashless” exercise provision entitling the Investors to convert the Warrants into shares of the Company’s common stock.
On November 24, 2008, the Company entered into agreements (the “Warrant Modification Agreements”) with each of the holders of the Warrants. Pursuant to the Warrant Modification Agreements, the Company and each of the Warrant holders agreed to amend the Warrants so that (1) the Original Exercise Price would be reduced to $0.50 per share (the “New Exercise Price”), and (2) the proportionate anti-dilution adjustment to increase the number of shares of the Company’s common stock issuable upon exercise of the Warrants under certain circumstances would be eliminated in all cases except upon payment of stock dividends, or subdivision or combination of shares (such as through stock splits or reverse stock splits). While the New Exercise Price is considerably below the Company’s trading price generally over the last eighteen months, the Company determined that such a negotiated reduction was appropriate in order to obtain each Warrant holder’s agreement to eliminate the Proportionate Share Increase under most circumstances. Accordingly, the New Exercise Price was reached through independent negotiation with the holders of the Warrants in consideration of the elimination of the Proportionate Share Increase and not in any manner as an indication of the perceived value of the Company’s common stock.
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Following the modification of the Warrants, one of the parties redeemed 131,885 Warrants and elected to receive Common Shares using the cashless exercise provision, resulting in the issuance of 86,965 shares of common stock, and reducing the number of Warrants outstanding to 373,670 as of December 31, 2008.
Stock Incentive Plans
In 2004, the Company’s Board of Directors approved the 2004 Stock Incentive Plan (the “2004 Plan”), which provided for the issuance of up to 825,000 shares of common stock. On July 29, 2005, the Company adopted the 2005 Stock Incentive Plan (the “2005 Plan”). The 2005 Plan authorized the issuance of up to (i) 800,000 shares of common stock, plus (ii) any shares remaining available for issuance as of the effective date of the 2005 Plan under any prior plan, plus (iii) any shares of common stock subject to an award granted under a prior plan, in which the award was forfeited, cancelled, terminated, expired or lapsed for any reason without the issuance of shares. On May 23, 2007 the Company adopted the 2007 Stock Incentive Plan (the “2007 Plan”), which authorized the issuance of up to (i) 500,000 shares of common stock, plus (ii) any shares remaining available for issuance as of the effective date of the 2007 Plan under any prior plan, plus (iii) any shares of common stock subject to an award granted under a prior plan, in which the award was forfeited, cancelled, terminated, expired or lapsed for any reason without the issuance of shares.
The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. Options granted under the plans generally vest over periods ranging from date of grant to four years and expire in ten years. Principal assumptions are as follows: (a) expected future volatility for the Company's stock price is based on a combination of the Company’s historical volatility and observed volatility rates of other companies in the gaming industry, (b) expected term is based on historical exercise data and forfeitures, (c) the forfeiture rate is derived from an expectation of future forfeitures and (d) the risk-free rate is the rate on U.S. Treasury securities with a maturity equal to, or closest to, the expected life of the options.
At December 31, 2008 and December 31, 2007, options to purchase 2,023,263 and 2,034,825 shares of common stock, respectively, were outstanding and held by certain directors, officers, employees and independent contractors of the Company. The amount of related expense calculated using the Black-Scholes option pricing model and recognized in 2008, 2007 and 2006 was $1,106,113, $822,349 and $813,316, respectively.
A summary of option activity and changes during the year for the year ended December 31, 2008 is as follows:
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The weighted-average grant-date fair value of options granted during the years 2008, 2007 and 2006 was $1.43, $4.68 and $4.21, respectively. The total intrinsic value of options exercised during the years ended December 31, 2008, 2007 and 2006 were $0, $114,138 and $46,920, respectively.
A summary of the status of non-vested shares as of December 31, 2008, and changes during the year ended December 31, 2008 is presented below:
As of December 31, 2008, there was $2,397,865 of total unrecognized compensation cost related to non-vested options. This cost is expected to be recognized over a weighted-average period of 27.9 months.
The total fair value of options vested during the years ended December 31, 2008, 2007 and 2006 was $1,197,370, $912,879 and $441,417, respectively.
Note 11. Income Taxes
The total income tax expense (benefit) provided on pretax income and its significant components were as follows:
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A reconciliation of the statutory federal income tax expense (benefit) at 34% to loss before income taxes and the actual income tax expense (benefit) is as follows:
Deferred income taxes result from temporary differences between the reporting of amounts for financial statement purposes and income tax purposes. The net deferred tax assets and liabilities included in the consolidated financial statements include the following amounts:
As of December 31, 2008 and December 31, 2007, the Company has federal net operating loss carryforwards of approximately $24,427,000 and $19,330,000, respectively, North Carolina net economic loss carryforwards of approximately $11,311,000 and $9,588,000, respectively, California net operating losses in the amounts of approximately $431,000 and $330,000, respectively, and Canadian net operating losses in the amounts of $32,000 and zero, respectively. Included in the federal net operating loss carryforward is a deduction for the exercise of nonqualified stock options. However, the net operating loss attributable to the excess of the tax deduction for the exercised nonqualified stock options over the cumulative deduction recorded pursuant to FAS 123R in the consolidated financial statements is not recorded as a deferred tax asset. The benefit of the excess deduction of $37,000 will be recorded to additional paid in capital when the Company realizes a reduction in its current taxes payable. These carryforwards can be used to offset taxable income in future years, which expire through 2028. The Company also has research and experimentation tax credit carryforwards for both federal and North Carolina of approximately $538,000 and $35,000, respectively. These credit carryforwards may be used to offset both federal and North Carolina income taxes in future years through their expiration in 2027.
The Company records a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company has assessed its earnings history and anticipated earnings, the expiration date of the carryforwards and other factors and has determined that valuation allowances should be established against the deferred tax assets as of December 31, 2008 and 2007. The change in the valuation allowance of $2,102,751 for the year ended December 31, 2008 was due to the increase in net deferred tax assets, principally driven by increases in deferred tax assets related to depreciation of PokerPro systems, and loss carryforwards.
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FIN
The Company adopted the provisions of Statement of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109 (“FIN 48”), on January 1, 2007. As a result of the adoption of FIN 48, the Company recognized an $118,725 decrease in the deferred tax assets for the unrecognized income tax benefits that existed at December 31, 2006. The amount was fully offset by a valuation allowance. As such, this decrease had no impact on retained earnings in accordance with FIN 48. At the adoption date, the Company had $118,725 of unrecognized tax benefits, all of which would affect the effective tax rate if recognized, without consideration of the related valuation allowance previously recorded. The Company did not recognize any adjustment to reserves for uncertain tax positions as a result of the related implementation of FIN 48.
During 2007 and 2008, following adoption of FIN 48, the Company recognized decreases in the deferred tax asset for the unrecognized tax benefits related to tax positions taken in the current period. As a result, as of December 31, 2008, the Company’s unrecognized tax benefits increased to $537,706. The increase in unrecognized tax benefits related to tax positions from prior periods resulted from a change in management’s assessment that its tax positions would be more likely than not to be sustained. The change in the Company’s unrecognized tax benefits was fully offset by changes to the valuation allowance attributable to the related deferred tax assets. Accordingly, there was no impact on the tax provision, or on net loss.
The Company's policy is to include interest and penalties recognized in accordance with FIN 48 in the consolidated financial statements as a component of income tax expense. However, the unrecognized tax benefits at December 31, 2007 would not result in any interest or penalties to date as the amounts did not result in a reduction of income taxes previously payable by the Company.
The following table summarizes the changes to the amount of unrecognized tax benefits for the years ended December 31, 2008 and 2007:
The Company files U.S. federal, U.S. state and Canadian tax returns. 2004 through 2008 tax years remain subject to examination by the IRS for U.S. federal tax purposes, as do U.S. state tax returns by the appropriate state taxing authorities and the Canadian tax returns by Revenue Canada.
Note 12. Related Party Transactions
Transactions with Aristocrat
During 2006, Aristocrat International Pty. Limited and its affiliates (“Aristocrat”) purchased shares of the Company’s common stock. Aristocrat is a wholly owned subsidiary and affiliate of Aristocrat Leisure Limited, a leading global provider of gaming solutions that focuses primarily on video slot machines, progressive systems and casino management systems. As of December 31, 2008 and December 31, 2007 Aristocrat owned 16.4% and 16.5%, respectively, of shares of the Company’s common stock.
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The Company’s distribution agreement provides Aristocrat with the sole and exclusive right to globally (excluding the United States and Canada) distribute, market, enter into license agreements and, under certain circumstances, manufacture the PokerPro system. Aristocrat purchases PokerPro systems manufactured by the Company and pays the Company a portion of the license fees received from each customer in connection with Aristocrat’s licensing of the PokerPro system. License fees and equipment sales to Aristocrat of $608,724 and $3,777,862, respectively, were recorded in 2008, while $388,611 and $1,337,342, respectively, were recorded during 2007. As of December 31, 2008, accounts receivable balances totaling $114,053 were due from Aristocrat and included in the accompanying Consolidated Balance Sheets.
Office Lease
The Company currently leases its office and manufacturing facility from an entity owned and controlled by the Company’s President and Vice Chairman of the Board of Directors. The entity purchased the building while the Company was already a tenant. The lease terms were negotiated and are consistent with the rent paid by other tenants in the building. Rent expense recorded for the leased space for the year ended December 31, 2008, 2007, and 2006 was $219,600, $160,766, and $147,090, respectively, of which $45,490 was paid to the related party during 2006.
Founders’ Loan
On March 24, 2008, the Company entered into a loan agreement with Lyle A. Berman, James T. Crawford III, Arthur Lee Lomax and Gehrig H. “Lou” White. Messrs. Crawford, Lomax and White are the founders of the Company. Each of the lenders are also members of our board of directors, with Mr. Berman serving as Chairman and Mr. White serving as Vice Chairman. Upon closing, the lenders loaned the Company $2.0 million and the Company issued the lenders a promissory note in the principal amount of $2.0 million. The loan bears interest at 13% with all unpaid principal and interest payable on March 24, 2010. The Company intends to pay interest on a monthly basis and the loan may be repaid prior to maturity without penalty. The loan contains no restrictive covenants and is collateralized by security interests in the Company’s PokerPro systems deployed in North America and on cruise ships as of December 31, 2007. During 2008, the Company made $176,477 in aggregate interest payments and $0 in aggregate principal payments.
Note 13. Commitments and Contingencies
Leases
The Company leases its corporate office and manufacturing facility under a lease agreement with a term of 4 years. The lease requires the Company to pay property taxes, insurance and maintenance. This facility is approximately 21,600 square feet and is located in Matthews, North Carolina. This facility is leased by an entity owned and controlled by the Company’s President and Vice Chairman of the Board of Directors (see Note 10 - “Related Party Transactions”).
The Company also leases certain equipment under lease agreements with terms up to 3 years and a storage facility with a one-year term.
The following is a schedule by year of the future minimum lease payments due under agreements with terms extending beyond one year:
Rent expense for the years ended December 31, 2008, 2007 and 2006 was $261,688, $192,636 and $151,809, respectively.
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Employment Agreements
The Company has entered into employment agreements with certain officers that include commitments related to base salaries and certain benefits. These agreements have terms of two years.
Reviews and Audits by Regulatory Authorities
The Company’s operations are subject to a number of regulatory authorities, including various gaming regulators, the Internal Revenue Service, and other state and local authorities. From time to time, the Company is notified by such authorities of reviews or audits they wish to conduct. To date, reviews have been resolved with minimal, if any, financial impact to the Company. The state of North Carolina is currently performing a routine sales and use tax audit covering periods from 2004 through 2007. The Company may be subject to other income, property, sales and use, or franchise tax audits in the normal course of business. The Company believes it has complied with relevant regulations, and based on facts presently known, does not believe the outcome of the current audit will have a material adverse effect on the Company’s financial condition or results of operations.
Indemnification
The Company maintains directors’ and officers’ liability insurance for the benefit of its directors and certain of its officers. The Company has entered into a separate indemnification agreement with Lyle Berman, the Chairman of the Board of Directors, which provides for indemnification for related expenses including attorneys’ fees, judgments, fines and settlement amounts incurred by Mr. Berman in any action or proceeding.
The Company also indemnifies its casino customers from any claims or suits brought by a third party alleging infringement of a United States patent, copyright or mask work right. The Company agrees to pay all costs and damages, provided the customer provides prompt written notice of any claim.
Legal Proceedings
The Company is subject to claims and assertions in the ordinary course of business. Legal matters are inherently unpredictable and the Company’s assessments may change based on future unknown or unexpected events.
Tellis: On February 5, 2007, Tellis Software, Inc. (“Tellis”) filed a Complaint against the Company and Gehrig “Lou” White, the Company’s Vice Chairman of the Board of Directors and former Chief Executive Officer, in the United States District Court for the Southern District of Texas. The Complaint alleged that the Company breached a Software Development Agreement (the “Development Agreement”), that the Company and Mr. White committed fraud in connection with the Development Agreement and that the Company had been unjustly enriched and/or that Tellis was entitled to a quantum merit recovery. As to all counts, Tellis sought damages equivalent to a 2% equity interest in the Company and bonuses of up to $730,000, plus attorneys’ fees, costs, and interest. For the fraud count, Tellis also sought unspecified exemplary damages.
In December 2007, the parties settled the lawsuit, which was withdrawn with prejudice.
Lightning Poker™: On August 2, 2006, the Company was served with a complaint filed on July 25, 2006, in the United States District Court for the Eastern District of Pennsylvania, by Pokermatic, Incorporated, d/b/a Lightning Poker. The complaint alleged antitrust violations, unfair competition, civil conspiracy, trade slander, tortious interference and defamation, and sought a declaration of non-infringement of the Company’s design patent. The complaint sought treble damages, attorneys' fees and declaratory and injunctive relief.
On August 17, 2006, the Company asked the United States District Court in Philadelphia, Pennsylvania to dismiss the case or transfer venue and to award costs and attorneys’ fees. On September 27, 2006, the judge granted the Company’s request regarding improper venue and ordered the case transferred to the United States District Court for the Western District of North Carolina. The case arrived in United States District Court for the Western District of North Carolina on or about November 8, 2006.
On November 16, 2006, the case was dismissed without prejudice.
On March 17, 2008, the Company was served with a complaint filed on March 6, 2008, in the United States District Court for the District of New Jersey by Lightning Gaming, Inc. and Lightning Poker, Inc. The complaint alleges that the Company infringes United States Patent No. 7,306,516, owned by Lightning Poker, Inc. The complaint is seeking unspecified monetary damages from the Company as well as a permanent injunction enjoining the Company from infringing the patent or unfairly competing with the plaintiffs. The Company believes that either its products do not violate the patent that forms the basis of the lawsuit, that the patent is invalid, or both.
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On October 16, 2008, the Company announced that it had reached a mutually agreeable settlement of all outstanding litigation with Lightning Gaming, Inc. The settlement resulted in all lawsuits between the parties being withdrawn with prejudice, including Lightning Gaming, Inc.’s lawsuit alleging patent infringement filed in Federal District Court in New Jersey.
There was no material financial impact to the Company as a result of the settlement.
Note 14. Summarized Quarterly Financial Information (Unaudited)
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a)
Note that selling, general and administrative expenses for the third quarter of 2007 included higher than normal legal expenses, including a $250,000 accrual for settlement of the Tellis lawsuit discussed in Note 13.
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Note 15. Segment Information
In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, the Company reports segment information based on the “management approach”. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.
The Company’s business is organized and reported in two segments, PokerPro® and Heads-Up Challenge™, which are described in Note 1, Nature of Business and Significant Accounting Policies. The Heads-Up Challenge amusement product was launched and began operations during 2007 and the company’s operations during 2006 consisted solely of operating the PokerPro business; therefore no segment information has been presented for the year ended 2006. The Company evaluates the performance of its two segments primarily based on revenues and direct costs of revenue. The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies."
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The table below presents information about reported segments for the years ending December 31:
Amounts presented in the column labeled “Corporate and Other” primarily consist of assets that are not specifically associated with either segment, principally cash equivalents, investments and other corporate assets.
REVENUE BY GEOGRAPHIC AREA
Revenues by geographic area are determined based on the location of our customers. For fiscal 2008, 2007 and 2006, sales to customers outside the United States accounted for 63%, 44% and 55% of consolidated revenue, respectively. The following is revenues and long-lived assets by geographic area as of and for the years ended December 31:
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Note 16. Subsequent Events
On January 5, 2009, the Company exercised its rights under the UBS Rights Offering to sell the ARS investments to UBS at par. As a result, the Company received $1.0 million in net proceeds and liquidated its outstanding UBS Credit Facility in the amount of $2.9 million. Since the investments were redeemed at par, there was no realized gain or loss associated with this transaction. The Company has no remaining ARS investments and the UBS Credit Facility has been terminated.
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SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
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EXHIBIT INDEX
Exhibit No.
Description
Exhibit No.
Description
Exhibit No.
Description
Our SEC file number reference for documents filed with the SEC pursuant to the Securities Exchange Act of 1934, as amended, is 000-51572.