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SHFL > SEC Filings for SHFL > Form 10-Q on 6-Sep-2013All Recent SEC Filings

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Form 10-Q for SHFL ENTERTAINMENT INC.


6-Sep-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995

This Quarterly Report on Form 10-Q contains forward-looking statements. We consider such statements to be made under the safe harbor created by the federal securities laws to which we are subject. In some cases, you can identify forward-looking statements by the following words: "may," "might," "will," "could," "would," "should," "expect," "intend," "plan," "objective," "anticipate," "believe," "estimate," "predict," "project," "potential," "continue," "ongoing" or the negative of these terms or other comparable terminology intended to identify performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. Examples of such forward-looking statements include, without limitation, statements about or relating to the following:

? The pending, proposed acquisition of the Company, including the potential timing consummation of such transaction, pursuant to the terms of the Merger Agreement by and among the Company, Bally and Merger Sub;

? Business strategies, including with respect to development of new or enhanced products, investment of capital to maximize returns and build our economic engine, and our focus on leasing structures for commercialization of certain products to increase returns and gross margins;

? Increasing our Proprietary Table Games ("PTG") content through development or acquisitions of new proprietary titles;

? Expectations of increases in gross margins and revenues from leasing of certain products;

? The growth opportunities and revenue potential from our i-Table, i-Table Roulette and MD3 shuffler products;

? The benefits of our products;

? Continued volatility in sales revenue from our Utility segment;

? Expected sources of revenue in the Utility segment;

? Expectations of revenue in the current year from online products;

? Expectations that Electronic Gaming Machine ("EGM") revenues will continue to come from sales of EGMs in Australia, Asia and other markets;

? Expectations regarding revenue and placement increases in our EGM segment through the use of long-term financing arrangements;

? Expected growth of certain markets or our business in certain markets, including Asia, United States, Canada and Latin America;

? Cash and capital resources being sufficient to satisfy requirements for working capital, capital expenditures, debt service and other liquidity requirements of existing operations for at least the next 12 months;

? Expectations for online gaming to represent an opportunity for continued growth;

? Expectations with respect to outstanding litigation; and

? Expectations with respect to foreign currency exchange rate fluctuation risk.


Although we currently believe that we have a reasonable basis for each forward-looking statement contained in this Quarterly Report on Form 10-Q, we caution you that these statements are based on a combination of facts and factors currently known by us, as well as our projections of the future, about which we cannot be certain. Forward-looking statements reflect and are subject to inherent known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Risk factors that could cause actual results to differ materially from those expressed or implied by our forward-looking statements include, but are not limited to, the following:

? Difficulties or delays in the consummation of the acquisition of the Company under the Merger Agreement, including as a result of an inability to meet closing conditions, obtain necessary regulatory approvals, the failure to obtain the necessary debt financing arrangements set forth in the debt commitment letter received in connection with the proposed Merger, inability to obtain shareholder approval of such transaction, the possibility that costs related to the proposed Merger will be greater than expected, an inability to maintain compliance with the covenants set forth in the Merger Agreement and other risks and uncertainties that could delay or prevent the closing of such transaction;

? Failure to maintain our regulatory licenses or obtain new licenses where necessary;

? Legislative and regulatory changes that impact us or our customers;

? Non-compliance with the covenants in our senior secured credit agreement, including as a result of factors that are beyond our control;

? High volatility or extreme changes in foreign currency exchange rates;

? Difficulties or delays in, or being prevented from, carrying out acquisitions and subsequent integration of acquired businesses;

? Difficulties in maintaining and protecting our intellectual property rights;

? Potential infringement of the intellectual property rights of third parties;

? Adverse outcomes with respect to litigation regarding intellectual property, including our payment of damages, constraints on our business and operations and invalidation of our intellectual property;

? Involvement in other legal proceedings, and adverse outcomes with respect to such proceedings that could have a materially adverse effect on our business or prospects;

? Disruption or delays in our or our suppliers' manufacturing processes that could prevent us from meeting demand for our products;

? Revenue losses in any of our business segments due to technical difficulties or fraudulent activities experienced by end users;

? Inability to obtain market acceptance of products currently in development;

? Inability to maintain a competitive technological position with respect to our competitors and competitive products;

? Lower than expected revenues from our transition in certain products to a lease-based commercialization model;

? Decreased demand for our products, including as a result of developments with respect to competitive products;

? Adverse economic conditions in the gaming industry, which is our sole industry of focus; and

? Adverse developments with respect to economic, political, legal and other risks associated with our international sales and operations.

In addition, refer to the "Risk Factors" section in Part II, Item 1A of this Quarterly Report on Form 10-Q, as well as the "Risk Factors" section of our Annual Report on Form 10-K for the fiscal year ended October 31, 2012, as filed with the Securities and Exchange Commission on December 21, 2012, and as incorporated by reference in Part II, Item 1A of this Quarterly Report on Form 10-Q, for a discussion of other important factors that may cause our actual results to differ materially from those expressed or implied by our forward-looking statements. There can be no assurance that the proposed Merger will in fact be consummated. As a result of these factors, we cannot assure that the forward-looking statements will prove to be accurate. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. In light of the significant uncertainties in these forward-looking statements, these statements should not be regarded as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, or at all. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by each of these cautionary statements above.

The following discussion should be read in conjunction with "Item 8. Financial Statements and Supplementary Data" in the Annual Report on Form 10-K and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. All information presented herein is based on our fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to our fiscal years ended in October and the associated quarters of those fiscal years.


Overview

We are a leading global gaming supplier committed to making gaming more fun for players and more profitable for operators through product innovation, and superior quality and service. We operate in legalized gaming markets across the globe and provide state-of-the-art, value-add products in five distinct segments: Utility products, which include automatic card shufflers and roulette chip sorters; Proprietary Table Games ("PTG"), which include live table games, side bets and progressives; Electronic Table Systems ("ETS"), which include various e-Table game platforms; Electronic Gaming Machines ("EGM"), which include video slot machines; and our newly introduced iGaming segment, which include online versions of our specialty table games offered in a free-to-play format and for real money gambling in regulated online markets. Each segment's activities includes the design, development, acquisition, manufacturing, marketing, distribution, installation and servicing of a distinct product line. Our products are manufactured at our headquarters in Las Vegas, Nevada, at our Australian headquarters in Milperra, New South Wales, Australia, as well as outsourced, for certain sub-assemblies in the United States, Europe and Asia.

We lease, license and sell our products. When we lease or license our products, we generally negotiate a month-to-month fixed fee contract or to a lesser extent, we enter into participation arrangements whereby casinos pay a fee to us based on a percentage of net win. When we sell our products, we offer our customers a choice between a sale, a longer-term sales-type lease or other long-term financing. We offer our products worldwide in regulated markets.

See Note 1 to our Condensed Consolidated Financial Statements for a more detailed discussion of our five segments.

On July 15, 2013, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") by and among the Company, Bally and Merger Sub. The Merger Agreement provides for the merger of Merger Sub with and into the Company (the "Merger"), with the Company surviving the Merger as a wholly owned subsidiary of Bally. At the effective time of the proposed Merger, on the terms and subject to the conditions set forth in the Merger Agreement, each share of SHFL Common Stock issued and outstanding immediately prior to such time, other than shares of SHFL Common Stock owned by SHFL, Bally or Merger Sub (each of which will be cancelled) and shares of SHFL Common Stock with respect to which appraisal rights are properly exercised and not withdrawn under Minnesota law, shall be automatically cancelled and converted into the right to receive $23.25 in cash, without interest. If the proposed Merger is consummated, shares of SHFL Common Stock will be delisted from the NASDAQ. No assurance can be given that the proposed Merger will be completed.

Consummation of the proposed Merger is subject to customary conditions, including without limitation (i) the required approval of the Merger Agreement by SHFL's shareholders, (ii) the expiration or early termination of the waiting period applicable to the consummation of the proposed Merger under the HSR Act (which waiting period, as previously announced, expired as of 11:59 p.m. EDT on August 26, 2013 with no action by the Federal Trade Commission or the Department of Justice), (iii) the receipt of specified licenses, permits, and other approvals relating to SHFL's gaming operations issued by certain governmental authorities, (iv) the absence of any law or order that is in effect and restrains, enjoins or otherwise prohibits the proposed Merger, (v) the accuracy of the representations and warranties of the parties and compliance by the parties with their respective obligations under the Merger Agreement (subject to customary materiality qualifiers) and (vi) the absence of any change, effect, development or circumstance that, individually or in the aggregate, constitutes or is reasonably likely to constitute a Company Material Adverse Effect (as defined in the Merger Agreement).

The Merger Agreement contains certain termination rights for Bally and the Company. In connection with the termination of the Merger Agreement under specific circumstances, the Company may be required to pay to Bally a termination fee of $43.3 million.

The Merger Agreement contains certain limitations on the operations of the Company during the period prior to the effective time of the proposed Merger, including a prohibition on share repurchases by the Company.

For terms of the Merger Agreement, including circumstances under which the Merger Agreement can be terminated and the ramifications of such termination, as well as other terms and conditions, please refer to the Merger Agreement filed as Exhibit 2.1 to the Company's Current Report on Form 8-K, filed with the SEC on July 18, 2013. Additional information regarding the proposed Merger transaction will be contained in a definitive proxy statement to be filed by the Company with the SEC.


Strategy

We believe we enhance our customer and shareholder value through our execution of the following strategic priorities:

? An unwavering commitment to create innovative solutions and services for casino operators and compelling gaming experiences for players through enhanced customer centricity.
? Reinforce our relationships with our customers by providing enhanced efficiencies, security and profitability on the casino floor. We continue to work toward developing innovative products that anticipate and respond to their needs.

? Maintain a cost-conscious mindset, promote a lean culture, and serve as prudent stewards of shareholder capital.
? Seek long-term profitability and sustainability through our recurring revenue model. We plan to continue to invest capital in our lease business to maximize our return and build on our economic engine.

? Foster the spirit of invention and the commitment to innovation that is at the heart of our success. With nearly 2,500 worldwide patents, trademarks and copyrights granted and pending, our pipeline for new intellectual property is robust. We believe our intellectual property collectively represents one of the strongest portfolios in the industry and our success depends upon our ability to preserve, leverage and protect these core assets.
? Capitalize on existing and emerging markets, and the worldwide proliferation of gaming. A large part of our success in fiscal 2012 was turning opportunities into achievements. As new markets continue to emerge across the globe and as existing gaming markets continue to evolve, we strive to make the most of every opportunity that arises. We also believe that we have room to grow our footprint in existing markets - like Latin America, United States, Canada and Asia - in all or some of our product categories.

? Sound balance sheet management to fuel growth through:
o continued investment in our recurring revenue model, global intellectual property and research and development ("R&D"). We believe this will promote growth on our top and bottom line without relying on the introduction of significant new markets;

o continued examination of strategic acquisitions. We are seeking opportunities that are accretive to earnings, have strong existing recurring revenues and merit our efforts of integration; and
o use of our financial resources to improve our return to shareholders through continued deleveraging and evaluation of stock repurchases and/or dividends.

? Promote and foster internal staff development and deepen our bench strength. We know our success is directly attributable to the caliber of our workforce and we remain committed to each and every employee's development. We will continue to set the talent bar high.
? Drive margin improvement across all product categories. Our overall gross margin and operating margin have shown continuous improvement over the past four fiscal years. We plan to continue our process improvement initiatives and uncover additional operational efficiencies.

? Capitalize on opportunities created from existing online gaming markets and prepare ourselves for the potential legalization of Internet gambling in the United States. The gaming landscape is quickly evolving and we will strive to be a leading content-provider in this arena.

We are focused on our customers and on value-creation for our shareholders. We seek to maintain continuous improvement while keeping innovation at the core of our success. We believe that continued execution of our strategic plan is the best method to foster the growth of our business in fiscal 2013.

Sources of Revenue

We derive our revenue from the lease, license and sale of our products and by providing service to our leased, and in some cases, previously sold units. Consistent with our strategy, we have a continuing emphasis on leasing or licensing our products. When we lease or license our products, we generally negotiate month-to-month fixed fee contracts, or to a lesser extent, enter into participation arrangements whereby casinos pay us a fee based on a percentage of net win. Product lease contracts typically include parts and service. When we sell our products, we offer casinos a choice between a cash sale or to a lesser extent, long-term financing. We also offer a majority of our products for sale with an optional parts and service contract.

Currently, the majority of Utility segment revenue is derived from our automatic card shufflers. In addition to leasing shufflers, we also sell and service them. In the PTG segment, the majority of games placed are licensed to our customers on month-to-month license arrangements, which provides us with monthly royalty revenue. In the ETS segment, we derive revenue from fixed fee leases, participation arrangements, sales and service contracts. In the EGM segment, we derive revenue from selling the full EGM complement, as well as sales of game conversion kits, and to a lesser extent, participation and lease arrangements. The majority of our iGaming revenue has historically been related to licensing and settlement agreements with online operators. We plan to generate revenue in the current year from our suite of online products, which feature online versions of our specialty table games delivered via our proprietary content delivery platform to online operators. We anticipate revenue from real money gambling in regulated online markets, as well as free-to-play environments. We will continue to protect our intellectual property and pursue settlements where applicable.

The following points should be noted as they relate to each of our segments:

Utility

? We expect to continue to emphasize lease revenues in our Utility segment within the United States. One of the current growth drivers for this segment has been the MD3 shuffler upgrade initiative. The MD3 shuffler is our next generation upgrade for the legacy MD series shufflers. As the MD1 shuffler reaches its end of life where replacement parts will no longer be available, our strategy is to encourage our customers to upgrade the MD1 and MD2 shufflers, both leased and previously sold, with the MD3 shuffler. Our objective is that, over time, the majority of these placements will be leases. We expect revenue growth drivers to be our next generation shuffler models like the Deck Mate 2. We expect to upgrade previous models through both outright sales and leases of next generation shufflers.


? We expect to continue seeing volatility in sales revenue in our Utility segment. Factors that can impact sales include new openings, whereby certain operators may opt to allocate equipment expenses into initial capital budgets and thus purchase products outright. Additionally, sales may be positively impacted as the overall health of our customers improve and capital becomes more readily available. While we encourage leasing outside the United States, a large majority of our international Utility product placements historically have been sales. We are starting to see increased lease activity in international markets such as Asia and Latin America. Growth drivers for the Utility segment outside the United States are new jurisdictional openings, the expansion of existing markets, and growing demand for greater security and sophistication in existing casinos.

Proprietary Table Games

? The majority of our PTG segment revenue is derived from royalties and leases. While we have a strong leasing presence in the United States, we are constantly looking to expand our proprietary table games in other parts of the world where the current penetration of proprietary table games is lower. With global gaming expansion and the growing acceptance of specialty table games, we have recently seen some successes with new lease placements of our premium table games as well as progressives and side bets.

? Although the majority of our PTG revenue comes from our premium table games, we also derive a growing amount of revenue from progressive upgrades, add-ons and side bets. These products are available for our own proprietary table game titles as well as public domain games such as poker, blackjack, baccarat, craps and pai gow poker. These progressives, add-ons and side bets, offered almost exclusively through leases, are providing a growing share of our total PTG revenue.

? We also pursue opportunities to place PTG products in new properties and jurisdictions in the United States. Several states have either opened new casino properties or approved live table games over the past year, and we have seen significant placements of our table game products in those new jurisdictions.

? We intend to increase our PTG content through development and acquisition of new proprietary titles. By increasing our footprint with new titles, we hope to increase our domestic market penetration and expand further into international markets.

Electronic Table Systems

? Although we continually pursue opportunities to increase lease revenues in our ETS segment, the nature of the gaming landscape in the United States has gradually evolved whereby there are fewer racinos and electronic-only markets and more live gaming markets. As a result, we have seen some of our leased ETS products removed from those electronic-only markets as some states have approved live table games. While this has caused some setbacks in the growth of our domestic ETS business, we have been able to return some of these products to service in other markets such as Latin America and even position these products as low-denomination, labor-free alternatives to live tables in live markets. However, the live market placements typically do not perform to the same revenue and profitability levels as units in electronic-only markets. There are opportunities for our ETS suite of products in markets with strong player acceptance, such as Australia and Asia. Given our large install base of legacy e-tables in Australia, we believe there are upgrade opportunities with our refreshed FUSION line.

? Through development of new products and enhancements of our existing products we expect to generate revenue and growth for the ETS segment. New products include the following:
o In Australia and Asia, we have begun generating revenue from placements of our new multi-game feature on SHFL FUSION Hybrid, which offers enhanced live statistics at the touch of a button and allows the player to choose between multiple games. Similarly, we recently debuted additional features of SHFL FUSION Hybrid, which take the multi-game concept one step further by enabling concurrent wagering.

o We recently upgraded the SHFL FUSION Virtual platform to offer modular 22-inch widescreen terminals, new graphic displays, and a variety of configurable options such as SHFL FUSION Virtual Live Roulette, which incorporates a live wheel.
o We recently debuted our next generation Table Master Fusion product that shares a common modular terminal with SHFL FUSION Virtual and SHFL FUSION Hybrid. We expect this product to drive growth in domestic as well as international markets.

o The i-Table and i-Table Roulette combine an electronic betting interface with a live table game and graphically-enhanced central display touchscreens. We expect these products to provide us with growth opportunities in domestic and international markets if they achieve customer and player acceptance.


Electronic Gaming Machines

? Our EGM segment is primarily a sales model and we expect to continue to realize the majority of our EGM revenues from sales of EGMs in the global marketplace, such as Australia, Asia, the United States and other markets that make strategic sense.

? We expect that EGM revenue and placements in fiscal 2013 will continue above fiscal 2012 levels primarily driven by new game content and enhancements, continued momentum in emerging markets, and global market expansion. We also expect revenue and placements to increase through the continued use of long-term financing arrangements.

? A portion of our EGM revenue base comes from conversions of existing units to new game titles. We are continually developing new titles for our existing machines, and installation of these new titles provides us with an ongoing source of conversion revenue.

? We also expect global growth in markets such as Asia, Latin America and the United States. In the prior fiscal year, we grew our footprint in Mexico, Latin America, the Philippines and Macau.

iGaming

? Because of the strength of our brand portfolio and our technological expertise, we believe that online gaming has significant growth potential for our business, particularly in current regulated online markets, like Europe, and potential new ones, such as the United States. As the regulatory environment of the U.S. market potentially evolves, either on a federal or state-by-state level, we are positioning ourselves to capitalize on opportunities to supply online operators with a variety of content, similar to our land-based strategy.

? We continue to invest in our iGaming infrastructure and will continue to expand our team in order to best capitalize on the various existing and potential online opportunities.

? We plan to generate revenue in the current year from our suite of online products, which feature online versions of our specialty table games delivered via our proprietary content delivery platform to online operators. We anticipate revenue from real money gambling in regulated online markets, as well as free-to-play environments.

? We have successfully sought enforcement and remedies against parties that infringed our intellectual property and will continue to protect and pursue settlements where applicable.

Expenses

Cost of sales and service and cost of leases and royalties primarily include the cost of products sold, depreciation of leased assets, amortization of product-related intangible assets, service, manufacturing overhead, shipping and installation. Operating expenses allocated to segments include other costs directly identified with each segment, such as product specific R&D, product approval costs, product-related litigation expenses, product management, sales commissions and other directly-allocable sales expenses. We continue to expend significant efforts on the development of our next generation products and product enhancements in each segment, which includes development of our online . . .

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