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ITSI > SEC Filings for ITSI > Form 10-K on 9-Jul-2013All Recent SEC Filings

Show all filings for INTERNATIONAL LOTTERY & TOTALIZATOR SYSTEMS INC

Form 10-K for INTERNATIONAL LOTTERY & TOTALIZATOR SYSTEMS INC


9-Jul-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

The discussion in this filing contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth or implied by forward-looking statements. These risks and uncertainties include dependence on business from foreign customers sometimes in politically unstable regions, political and governmental decisions as to the establishment of lotteries and other wagering industries in which our products are marketed, fluctuations in period-to-period operating results, the absence of significant contract backlog, and other factors described in section 1A. Risk Factors in this Form 10-K.

Critical Accounting Policies

Use of Estimates

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States. Accordingly, we are required to make estimates, judgments and assumptions that we believe are reasonable. We base our estimates on historical experience, contract terms, observance of known trends in our company and the industry as a whole, and information available from other outside sources. Estimates affect the reported amounts and related disclosures. Actual results may differ from initial estimates. The areas most sensitive to estimation are revenue recognition, warranty reserves, inventory valuation, the allowance for doubtful accounts and the deferred tax valuation allowance.

Revenue Recognition

Our revenues are derived primarily from the sales of complete wagering systems, lottery terminals, the OpenElect® and PBC voting systems, other software and software support services. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and the title and risk of loss have been transferred. Service revenues are recognized as the services are rendered, and the related costs of services are recognized on a time and materials basis.

Revenue Recognition for Arrangements with Multiple Deliverables

For multi-element arrangements that include hardware products containing software essential to the hardware product's functionality, undelivered software elements that relate to the hardware product's essential software, and undelivered non-software services, we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables:
(i) vendor-specific objective evidence of fair value ("VSOE"), (ii) third-party evidence of selling price ("TPE") and (iii) best estimate of the selling price ("ESP"). VSOE generally exists only when we sell the deliverable separately and VSOE is the price actually charged for that deliverable. TPE is determined based on competitor prices for similar deliverables when sold separately. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a standalone basis.

For sales of hardware products, we provide various hardware components containing software essential to the hardware product's functionality, and other components depending on the customers' needs. We allocate revenue to these deliverables using the relative selling price method. Because we have not established VSOE or TPE for the hardware, with essential software, revenue is allocated based on ESPs. Determining ESPs requires management's judgment. Revenue is recognized upon shipment of the hardware and the related essential software, provided the other conditions for revenue recognition have been met. We also provide software support and product support services on a standalone basis from the sales of the hardware. Amounts allocated to software support and product support services are based on VSOE using hourly or daily billing rates. Revenue is deferred until the services are performed. For annual software licenses, we use VSOE. Amounts allocated to annual software licenses are deferred and recognized on a straight-line basis over the service period, which is typically one year.


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We consider multiple factors depending on the unique facts and circumstances related to each deliverable when determining ESPs for deliverables without VSOE or TPE. Key factors considered by the management in developing the ESPs for the hardware include the costs of manufacture and what a customer would reasonably pay based on the features being offered, trends in the market place, size of the territory, and competitive prices. If the facts and circumstances underlying the factors change, including the estimated or actual costs incurred to provide the hardware with the essential software, or should future facts and circumstances lead the management to consider additional factors, our ESP for the hardware with essential software related to future sales could change.

Revenue Recognition for Percentage-of-Completion Method

For our complete wagering and lottery systems, we recognize revenue by using the percentage-of-completion method when the contracts for complete systems fulfill the following criteria:

1. Contract performance extends over long periods of time;

2. The software portion involves significant production, modification or customization;

3. Reasonably dependable estimates can be made on the progress towards completion, contract revenues and contract costs; and

4. Each element is essential to the functionality of the other elements of the contracts.

Under the percentage-of-completion method, sales and estimated gross profits are recognized as work progresses. Progress toward completion is measured by the ratio of costs incurred to total estimated costs. Revenue and gross profit may be adjusted prospectively for revisions in estimated total contract costs. If the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract is recorded in the period in which it becomes evident. The total estimated loss includes all costs allocable to the specific contract.

In addition to the software portion of a complete system, we develop software for our customers in accordance with the specifications stipulated in a software supply contract. Generally, these contracts are related to additional features or modules to be added to the application software that we have previously developed for our customers. Each software contract is reviewed individually to determine the appropriate basis of recognizing revenue.

Deferred Revenues and Deferred Cost of Revenues

Deferred revenues of approximately $5.4 million and $687,000 as of April 30, 2013 and 2012, respectively, represent prepayments for products and services related to lottery terminals, use of the OpenElect® and PBC voting systems and other software and technical support services. Deferred cost of revenues of approximately $132,000 and $6,000 as of April 30, 2013 and 2012, respectively, consist of the direct costs associated with lottery terminals, software support and manufacture of voting systems. We will recognize the revenues and related cost of revenues upon fulfillment of the prescribed criteria for revenue recognition.

Allowance for Doubtful Accounts

The estimate for the allowance for doubtful accounts is based primarily upon our company's historical bad debt experience with individual customers and any known specific issues or disputes that exist as of the balance sheet date.


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Warranty Reserves

Estimated warranty costs are accrued as revenues are recognized. Warranty reserves are based on historical trends and are adjusted periodically to reflect actual experience. Customers do not have a right to return, except for defective products. The most recent inventory cost is used to determine the value of potential warranty costs. Estimated reserves for warranty obligations are accrued as follows:

1. Contracts - Contract warranties are specific to the individual contracts. Estimated reserves for warranty obligations are accrued as revenue is recognized. Hardware and software components may be warranted separately:

a. Hardware - The warranty phase for terminals or terminal kits commences upon shipment and can extend from six months to 12 months depending on the specific contract terms.

b. Software - The warranty phase typically represents a six to twelve-month period of time after delivery, as defined by the specific contract terms.

2. Spares - Terminal replacement parts are warranted to be free from defects for 90 days from the date of shipment. Based on historical experience, warranty costs for spares have been immaterial.

3. Other - Specific provisions have been made to cover a small number of particular replacement parts for specific customers.

Costs and Estimated Earnings in Excess of Billings on Uncompleted Contracts and Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts

Billings on uncompleted long-term contracts may be greater than or less than incurred costs and estimated earnings. Accordingly, these differences are recorded as an asset or liability on the balance sheet. As our revenue recognized on these long-term contracts includes management's estimates of total anticipated costs, the amounts in costs and estimated earnings in excess of billings on uncompleted contracts and billings in excess of costs and estimated earnings on uncompleted contracts also include these estimates.

Inventory Valuation

We periodically review the inventory quantities on hand and record a provision for excess and obsolete inventories based on the following factors:

· Terminal models still currently in the field;

· The average life of the models;

· The requirement for replacement parts on older models; and

· The future sales projections.

Valuation of Deferred Tax Assets

We regularly evaluate our ability to recover the reported amount of our net deferred tax assets. We consider several factors, including our estimate of the likelihood that we will generate sufficient taxable income in future years in which temporary differences will reverse.


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Results of Operations

Revenue Analysis
                                             Years Ended
(Amounts in thousands)                       April 30,
Revenues                        2013          2012         Change
Products:
Contracts                      $  8,290      $  9,313      $ (1,023 )
Spares                              543         1,011          (468 )
Licensing                           483           412            71
Total Products                    9,316        10,736        (1,420 )
Services:
Software Support                    776           787           (11 )
Product Servicing and Support       479           561           (82 )
Total Services                    1,255         1,348          (93)
                              $  10,571     $  12,084     $  (1,513 )

Significant fluctuations in year-to-year revenue are expected in both gaming and voting industries. Individual contracts are generally of considerable value, and the timing of contracts or sales of spare parts does not occur in a predictable trend. Contracts from the same customer may not recur or generally do not recur in the short-term. Accordingly, comparative results between periods may not be indicative of trends in contract revenue.

The current domestic and global economic slowdown and tightening of the credit markets may adversely affect our business and financial condition in ways that we cannot reasonably predict. For the gaming segment, due to the tightening of the credit markets, our potential and existing customers may not be able to secure financing for lottery projects which may effectively impact our revenue potential. For the voting segment, various government entities and jurisdictions have experienced severe budget constraints which could compel them to delay or cancel their purchasing decisions, and hence, impact our ability to generate revenue.

Contract revenue for the year ended April 30, 2013 was approximately $8.3 million, compared to $9.3 million for fiscal 2012. The decrease is primarily due to lower turnkey lottery system sales and decreased contract activities in the voting segment, compared to those in fiscal 2012. The decrease is partially offset by the increase in hardware component sales related to the totalizator industry and a lottery system contract.

Spares revenue for the year ended April 30, 2013 was $543,000, compared to $1 million for fiscal 2012, reflecting lower customer demand for spare parts in fiscal 2013. We derived spares revenue from various customers for shipments of spare orders during the years ended April 30, 2013 and 2012. Customer demand for spare parts fluctuates from period to period and may not be indicative of trends in spares revenue.

Licensing revenue for the year ended April 30, 2013 was $483,000, compared to $412,000 for fiscal 2012. We derived licensing revenue from executed voting and lottery contracts. Higher licensing revenue was primarily due to additional executed licensing agreements related to the voting segment.

Software support revenue for the year ended April 30, 2013 was $776,000, compared to $787,000 for fiscal 2012. Software support revenue remained relatively flat.

Product servicing and support revenue decreased to $479,000 in 2013 from $561,000 in 2012. The decrease was primarily due to lower demand for support services from customers in the gaming segment, partially offset by slightly higher demand for support services in the voting segment.

Related party revenue of approximately $4.2 million accounted for 40% of total revenue in the year ended April 30, 2013, compared to $6.1 million or 51% of total revenue in fiscal 2012.


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Cost of Sales and Gross Profit Analysis

The following table summarizes the cost of sales and gross profit margins as a
percentage of total revenues for each of the periods shown:
                                        Years Ended
                                         April 30,
(Amounts in thousands)          2013                   2012
Revenues:
Products                 $  9,316        88 %   $ 10,736        89 %
Services                    1,255        12 %      1,348        11 %
  Total revenues         $ 10,571       100 %   $ 12,084       100 %

Cost of sales:
Products                 $  6,282        59 %   $  7,792        65 %
Services                      413         4 %        511         4 %
  Total costs of sales   $  6,695        63 %   $  8,303        69 %

Gross profit:
Products                 $  3,034        29 %   $  2,944        24 %
Services                      842         8 %        837         7 %
  Total gross profit     $  3,876        37 %   $  3,781        31 %

In general, individual contracts are significant in value and are awarded in a highly competitive bidding process. Gross profit margin varies from one contract to another, depending on the size of the contract and the competitiveness of market conditions. Accordingly, comparative results between periods may not be indicative of trends in gross profit margin.

Overall gross profit margin was 37% for fiscal 2013, compared to 31% for fiscal 2012. Higher gross profit margin was primarily due to lower production overhead costs resulting from the allocation of labor resources to contract activities. In addition, an impairment charge of approximately $334,000 associated with kit inventory reflected in cost of sales for fiscal 2012 attributed to the variance in gross profit margin.

Other Operating Expenses Analysis
                                                            Years Ended
                                                             April 30,
                                                2013                          2012
(Amounts in thousands)                            % of Revenue                  % of Revenue
Research and Development              $     -                 - %   $    31                 - %
Selling, General and Administrative     2,325                22 %     2,498                21 %
Other Operating Expenses              $ 2,325                22 %   $ 2,529                21 %

Research and Development Expenses

We did not incur any research and development ("R&D") expenses for the fiscal 2013. For the year ended April 30, 2012, R&D expense was approximately $31,000. R&D expense consisted primarily of labor costs for the development of a new product in the gaming segment. While we continue to enhance our products, we anticipate R&D expenses will be minimal in the coming fiscal year as we dedicate our efforts to the marketing and sale of new voting systems.

Selling, General and Administrative

Selling, general and administrative ("SG&A") expenses for the year ended April 30, 2013 decreased by $173,000 compared to those of prior fiscal 2012, reflecting lower expenses associated with marketing and proposal efforts. We anticipate SG&A expenses will increase moderately in fiscal 2014 as we continue to increase our sales and marketing efforts.


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Income Tax Benefit

In fiscal 2013, we recorded an income tax benefit of approximately $1.6 million related to a tax benefit for the reduction in the valuation allowance. We reduced the valuation allowance after determining that a portion of the deferred tax assets is more likely than not to be realizable due to expected future income.

Liquidity and Capital Resources

Liquidity

Our net working capital at April 30, 2013 was approximately $7.8 million.

Contract backlog at April 30, 2013 was approximately $18.3 million. Of this amount, approximately $11 million was associated with a gaming contract executed with a related customer. The remaining contract backlog amount of approximately $7.3 million was related to gaming and voting contracts with unrelated customers. As of April 30, 2013, approximately $5.2 million of the contract backlog has been paid by customers.

Additional sources of cash through April 2014 are expected to be derived from spares revenue, software support and election support service revenues. Uses of cash are expected to be for normal operating expenses and costs associated with contract execution.

While we anticipate that we will be successful in obtaining additional product or service contracts to enable us to continue normal operations through April 30, 2014, there can be no assurance we will be able to acquire new contracts.

In the highly competitive industry in which we operate, operating results may fluctuate significantly from period to period. We anticipate our cash flows from operations, expected contract payments and available cash will be sufficient to enable us to meet our liquidity needs through at least April 30, 2014. Although we are not aware of any particular trends, in the event that we are unable to secure new business, we may experience reduced liquidity or insufficient cash flows.

The following table summarizes our cash flow
activities:
                                                                      Years Ended
                                                      April 30,       April 30,        Increase
                                                        2013            2012          (Decrease)
(Amounts in thousands)
Cash flow comparative:
Operating activities                                 $     5,612     $    (1,156 )   $       6,768
Investing activities                                      (1,136 )            58            (1,194 )
Net increase (decrease) in cash and cash
equivalents                                          $     4,476     $    (1,098 )   $       5,574

Cash Flow Analysis

Significant fluctuations in cash flows from operating, investing and financing activities are expected in the gaming and voting industries because factors such as working capital needs, value of contracts, and timing of contracts and payments do not occur in a predictable trend. Accordingly, comparative results between periods are not indicative of trends in cash flow activities.

Operating Activities

Net cash provided by operating activities was approximately $5.6 million in fiscal 2013, compared to net cash used in operating activities of approximately $1.1 million in fiscal 2012. The primary factors contributing to the change in the reported cash flow amounts related to increased deferred revenues, increased accounts payable for inventory-related purchases, and completion of contract deliverables. These were partially offset by increased accounts receivable due to the timing of contract deliveries and the decrease in inventories.


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Investing and Financing Activities

Net cash used in investing activities was approximately $1.1 million in fiscal 2013, compared to net cash provided by investing activities of $58,000 in 2012. Net cash used in investing activities for the year ended April 30, 2013 resulted from purchases of certificates of deposit, partially offset by the redemption of a matured certificate of deposit.

Capital expenditures amounted to $141,000 in fiscal 2013, compared to $191,000 in fiscal 2012. Expenditures in fiscal 2013 were primarily related to voting and computer equipment. Capital expenditures in fiscal 2012 were related to computer and manufacturing equipment.

There were no financing activities for the years ended April 30, 2013 and 2012.

Capital Resources

As of April 30, 2013, we did not have outstanding credit facilities.

Foreign Currency Fluctuation

Our reporting currency is the U.S. dollar. Sales are denominated almost exclusively in U.S. dollars. Occasionally, sales have been effected in foreign currencies. Fluctuations in exchange rates from reporting period to reporting period between various foreign currencies and the U.S. dollar may have an impact on our revenue and expense. Such effect may be material in any individual reporting period. No material foreign currency transactions occurred during the years ended April 30, 2013 and 2012.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our balance sheet, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Recent Accounting Pronouncements

The Financial Accounting Standards Board ("FASB") had issued certain other accounting pronouncements as of April 30, 2013 that will become effective in subsequent periods; however, we do not believe any of those pronouncements are relevant to our business or would have significantly affected our financial accounting measurements or disclosures had they been in effect during fiscal 2013.

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