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ITSI > SEC Filings for ITSI > Form 10-Q on 13-Mar-2014All Recent SEC Filings

Show all filings for INTERNATIONAL LOTTERY & TOTALIZATOR SYSTEMS INC

Form 10-Q for INTERNATIONAL LOTTERY & TOTALIZATOR SYSTEMS INC


13-Mar-2014

Quarterly Report


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

NOTE REGARDING FORWARD-LOOKING STATEMENTS

SAFE HARBOR STATEMENT PURSUANT TO SECTION 21E OF THE SECURITIES EXCHANGE ACT OF
1934

This report contains certain forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or anticipated results, including those set forth under the heading "Risk Factors" and elsewhere in, or incorporated by reference into, this report. In some cases, you can identify forward-looking statements by terms such as "may," "intend," "might," "will," "should," "could," "would," "expect," "believe," "anticipate," "estimate," "predict," "potential," or the negative of these terms. These terms and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. The forward-looking statements in this report are based upon management's current expectations and belief, which management believes are reasonable. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor or combination of factors, or factors we are aware of, may cause actual results to differ materially from those contained in any forward-looking statements. You are cautioned not to place undue reliance on any forward-looking statements. These statements represent our estimates and assumptions only as of the date of this report. Except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including such factors, among others, as market acceptance and market demand for our products and services, pricing, the changing regulatory environment, the effect of our accounting policies, potential seasonality, industry trends, adequacy of our financial resources to execute our business plan, our ability to attract, retain and motivate key technical, marketing and management personnel, and other risks described from time to time in periodic and current reports we file with the United States Securities and Exchange Commission, or the "SEC." You should consider carefully the statements under "Item 1A. Risk Factors" and other sections of this report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements.

CRITICAL ACCOUNTING POLICIES

Use of Estimates

Our condensed consolidated financial statements have been prepared in accordance 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. There have been no material changes to the critical accounting policies outlined in the Company's annual report on form 10-K for the fiscal year ended April 30, 2013.


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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.

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 marketplace, 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 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.


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RESULTS OF OPERATIONS


Revenue Analysis                      Three Months Ended                    Nine Months Ended
(Amounts in thousands)                    January 31,                          January 31,
Revenues                         2014        2013       Change        2014        2013        Change
Products:
Contracts                       $ 3,547     $ 1,567     $ 1,980     $ 19,095     $ 5,924     $ 13,171
Spares                               49          54          (5 )        248         530         (282 )
Licensing                           103          88          15          381         315           66
Total Products                    3,699       1,709       1,990       19,724       6,769       12,955
Services:
Software Support                    266         195          71          706         594          112
Product Servicing and Support        32         102         (70 )        307         330          (23 )
Total Services                      298         297           1        1,013         924           89
                                $ 3,997     $ 2,006     $ 1,991     $ 20,737     $ 7,693     $ 13,044

Significant fluctuations in period-to-period contract revenue are expected in both gaming and voting industries since individual contracts are generally considerable in value, and the timing of contracts does not occur in a predictable trend. Contracts from the same customer generally may not recur or generally do not recur in the short-term. Accordingly, comparative results between quarters 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 business, due to the tightening of the credit markets, our potential and existing customers may not be able to secure financing for lottery projects which could effectively impact our revenue potential. For the voting business, 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 three months ended January 31, 2014 was approximately $3.5 million, compared to $1.6 million for the corresponding period in 2013. Higher contract revenue was primarily due to increased sales related to both the gaming and voting segments. For the nine months ended January 31, 2014, contract revenue was approximately $19.1 million, compared to $5.9 million for the corresponding period in 2013. Significantly higher contract revenue was primarily due to lottery product and hardware component sales related to the gaming and totalizator industries. The increase was partially offset by completion of a lottery contract and the absence of turnkey lottery system sales.

Spares revenue for the three months ended January 31, 2014 remained relatively flat at $49,000, compared to $54,000 for the same period in 2013. Spares revenue for the nine months ended January 31, 2014 was $248,000, compared to $530,000 for the corresponding period in 2013. The decrease was primarily due to lower demand for spare parts from an unrelated customer in the gaming segment. Customers' demand for spare parts fluctuates from period to period.

Licensing revenue for the three months ended January 31, 2014 was $103,000, compared to $88,000 in 2013. For the nine months ended January 31, 2014, licensing revenue was $381,000, compared to $315,000 for the corresponding period in 2013. The increases in licensing revenues were primarily due to additional executed licensing agreements related to the voting segment. We derive licensing revenue from both voting and lottery contracts.

Software support revenue for the three months ended January 31, 2014 was $266,000, compared to $195,000 for the same period in 2013. For the nine months ended January 31, 2014, software support revenue was $706,000, compared to $594,000 in the same period in 2013. Higher software support revenues were primarily due to increased fees to support a customer in the gaming segment.


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Product servicing and support revenue for the three months ended January 31, 2014 was $32,000, compared to $102,000 for the same period in 2013. For the nine months ended January 31, 2014, product servicing and support revenue was $307,000, compared to $330,000 for the same period in the prior year. The decreases were primarily due to lower demand for support services in the voting segment, partially offset by increased support services from an unrelated customer in the gaming segment.

Related party revenue of approximately $2.9 million accounted for 73% of total revenue in the three months ended January 31, 2014, compared to $646,000 or 32% of total revenue in the corresponding period in 2013. For the nine months ended January 31, 2014, related party revenue of approximately $11.7 million accounted for 56% of total revenue, compared to $3.7 million or 48% of total revenue in the corresponding period in 2013.

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:

                                   Three Months Ended                            Nine Months Ended
                                       January 31,                                  January 31,
(Amounts in thousands)         2014                  2013                   2014                  2013
Revenues:
Products                 $ 3,699        93 %   $ 1,709        85 %   $ 19,724        95 %   $ 6,769        88 %
Services                     298         7 %       297        15 %      1,013         5 %       924        12 %
Total revenues           $ 3,997       100 %   $ 2,006       100 %   $ 20,737       100 %   $ 7,693       100 %

Cost of sales:
Products                 $ 2,083        52 %   $ 1,372        68 %   $ 12,829        62 %   $ 4,222        55 %
Services                      76         2 %       146         7 %        314         2 %       349         5 %
Total costs of sales     $ 2,159        54 %   $ 1,518        75 %   $ 13,143        64 %   $ 4,571        60 %

Gross profit:
Products                 $ 1,616        40 %   $   337        17 %   $  6,895        33 %   $ 2,547        33 %
Services                     222         6 %       151         8 %        699         3 %       575         7 %
Total gross profit       $ 1,838        46 %   $   488        25 %   $  7,594        36 %   $ 3,122        40 %

In general, individual contracts are significant in value and certain contracts are awarded in a highly competitive bidding process. The 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 quarters and fiscal years may not be indicative of trends in gross profit margin.

Overall gross profit margin was 46% for the three months ended January 31, 2014, compared to 25% for the corresponding period in 2013. Significantly higher gross profit margin in the third quarter of 2014 was primarily due to increased contract sales activities and low cost structures. For the nine months ended January 31, 2014, overall gross profit margin was 36% compared to 40% for the corresponding period in 2013. Decreased gross profit in 2014 was primarily due to increased production overhead costs related to the voting segment.


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Selling, General and Administrative

Selling, general and administrative ("SG&A") expenses for the three months ended January 31, 2014 were $688,000, compared to $580,000 in the same period in 2013. For the nine months ended January 31, 2014, SG&A expenses were $2.1 million, compared to $1.8 million for the corresponding period in 2013. Higher SG&A expenses in 2014 were primarily due to increased legal and professional fees, and higher expenses incurred for marketing activities related to the voting segment, partially offset by lower employee related and trade show expenses.

Income Tax Provision

The provisions for income taxes were approximately $200,000 and $1.9 million for the three and nine months ended January 31, 2014, respectively. The effective rate was 34.73% for 2014, compared to a minimal effective rate for 2013. The increase in the effective rate for 2014 was due to the reversal of a portion of the valuation allowance and recording of a deferred tax asset at April 30, 2013. This deferred tax asset was fully recognized in the nine months ended January 31, 2014.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Our net working capital as of January 31, 2014 was approximately $11.4 million.

Contract backlog as of January 31, 2014 was approximately $2.9 million. Contract backlog is primarily related to voting contracts with unrelated customers. As of January 31, 2014, $536,000 of the contract backlog has been paid by customers.

Additional sources of cash through January 31, 2015 are expected to be derived from spares, software and technical support and licensing revenues. Uses of cash are expected to be for normal operating expenses and costs associated with contract deliverables.

While we anticipate that we will be successful in obtaining additional product or service contracts to enable us to continue normal operations through January 31, 2015, there can be no assurance that we will be able to acquire new contracts.

In the highly competitive industries in which we operate, operating results may fluctuate significantly from period to period. We anticipate that 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 January 31, 2015. 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:

                                                                    Nine Months Ended
                                                      January 31,       January 31,       Increase
                                                         2014              2013          (Decrease)
(Amounts in thousands)
Condensed cash flow comparative:
Operating activities                                 $       3,486     $       3,734     $      (248 )
Investing activities                                           864                33             831
Net increase in cash and cash equivalents            $       4,350     $       3,767     $       583


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Cash Flow Analysis

Net cash provided by operating activities was approximately $3.5 million for the nine months ended January 31, 2014, compared to $3.7 million in 2013. The principal components of the net decrease in cash flow from operations were the decreased deferred revenues and accounts payable. These were partially offset by net income of approximately $3.6 million, a decrease in inventory reflecting shipments, a decrease in deferred income taxes, and a decrease in accounts receivable.

Net cash provided by investing activities was $864,000 for the nine months ended January 31, 2014, compared to $33,000 in 2013. The increase in net cash flow from investments was due to the redemption of the matured certificates of deposit. Lower capital expenditures incurred in 2014 also attributed to the increase in new cash flow from investments.

There were no financing activities during the nine months ended January 31, 2014 or 2013.

Capital Resources

As of January 31, 2014, we did not have outstanding credit facilities.


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