UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-QSB

 

(Mark One)

ý                                 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended:  September 30, 2004

 

OR

 

o                                 TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE EXCHANGE ACT

 

For the transition period from:                                    to                                    

 

Commission file number:  001-32161

 

VendingData Corporation

(Exact name of small business issuer as specified in its charter)

 

Nevada

 

91-1696010

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

6830 Spencer Street, Las Vegas, Nevada  89119

(Address of principal executive offices)

 

(702) 733-7195

(Issuer’s telephone number)

 

 

(Former name, former address and former fiscal year, if changed since last report)

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:
17,198,198 shares of common stock, $.001 par value, as of September 30, 2004

 

Transitional Small Business Disclosure Format (check one):  Yes o No ý

 

 


 

VENDINGDATA CORPORATION

 

FORM 10-QSB

 

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

 

 

 

Item 1.

Financial Statements.

 

 

 

 

 

Balance Sheets

 

 

 

 

 

Statements of Operations

 

 

 

 

 

Statements of Cash Flows

 

 

 

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.

 

 

 

 

 

Overview

 

 

 

 

 

Critical Accounting Policies and Estimates

 

 

 

 

 

Results of Operations

 

 

 

 

 

Liquidity and Capital Resources

 

 

 

 

ITEM 3.

CONTROLS AND PROCEDURES

 

 

 

 

PART II – OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings.

 

 

 

 

Item 2.

Changes in Securities.

 

 

 

 

Item 3.

Defaults Upon Senior Securities.

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders.

 

 

 

 

Item 5.

Other Information.

 

 

 

 

Item 6.

Exhibits and Reports on Form 8-K.

 

 

i



 

PART I — FINANCIAL INFORMATION

 

Item 1.  Financial Statements.

 

VENDINGDATA CORPORATION

Balance Sheets

 

 

 

September 30, 2004

 

December 31, 2003

 

 

 

(unaudited)

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

2,685,355

 

$

11,526,664

 

Current portion of accounts receivable, trade, net of allowance for uncollectables of $149,190 and $125,530

 

3,863,576

 

2,354,054

 

Due from affiliate

 

40,602

 

31,802

 

Other receivables

 

99,212

 

29,836

 

Inventories

 

5,721,798

 

4,150,414

 

Prepaid expenses

 

391,658

 

52,028

 

 

 

12,802,201

 

18,144,798

 

 

 

 

 

 

 

Equipment rented to customers, net of accumulated depreciation of $506,727 and $316,245

 

458,217

 

608,555

 

Property and equipment, net of accumulated depreciation of $2,163,868 and $1,859,206

 

931,803

 

1,063,951

 

Intangible assets, net of accumulated amortization of $399,284 and $288,203

 

1,168,847

 

1,282,088

 

Due from affiliate - non current

 

118,800

 

118,800

 

Accounts receivable, trade, net of current portion, less unamortized discount

 

1,468,394

 

1,140,984

 

Deferred expenses

 

624,334

 

250,697

 

Deposits

 

931,058

 

1,284,827

 

Other assets

 

 

265,478

 

 

 

$

18,503,654

 

$

24,160,178

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of leases payable

 

$

1,861,697

 

$

2,237,073

 

Accounts payable

 

1,109,602

 

1,727,460

 

Accrued expenses

 

512,894

 

824,307

 

Deferred revenues, current portion

 

239,215

 

171,875

 

Short-term debt

 

238,250

 

270,743

 

Current portion of convertible debt

 

 

2,368,077

 

Customer deposits

 

196,360

 

178,805

 

 

 

4,158,018

 

7,778,340

 

 

 

 

 

 

 

Deferred revenues, net of current portion

 

243,175

 

219,890

 

Notes payable, net of current portion

 

3,250,000

 

 

Leases payable, net of current portion

 

560,133

 

1,916,723

 

 

 

8,211,326

 

9,914,953

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $.001 par value, 10,000,000 shares authorized, no shares issued and outstanding

 

 

 

Common stock, $.001 par value, 25,000,000 shares authorized, 17,198,198 and 16,765,580 shares issued and outstanding

 

17,198

 

16,766

 

Additional paid-in capital

 

59,760,641

 

58,810,806

 

Deficit

 

(49,485,511

)

(44,582,347

)

Total stockholders’ equity

 

10,292,328

 

14,245,225

 

Total liabilities and stockholders’ equity

 

$

18,503,654

 

$

24,160,178

 

 

See accompanying notes to financial statements.

 

1



 

VENDINGDATA CORPORATION

Statements of Operations

 

(UNAUDITED)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Sales

 

$

981,532

 

$

2,187,003

 

$

3,852,242

 

$

5,342,670

 

Rental

 

137,002

 

269,750

 

509,175

 

938,852

 

Other

 

42,782

 

9,399

 

152,317

 

39,485

 

 

 

1,161,316

 

2,466,152

 

4,513,734

 

6,321,007

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Cost of sales

 

865,232

 

1,403,546

 

2,714,857

 

3,566,691

 

Selling, general and administrative

 

1,581,271

 

1,267,831

 

4,459,217

 

4,303,496

 

Research and development

 

289,498

 

336,910

 

961,058

 

709,770

 

Inventory write down

 

575,446

 

 

575,446

 

 

 

 

3,311,447

 

3,008,287

 

8,710,578

 

8,579,957

 

Loss from operations

 

(2,150,131

)

(542,135

)

(4,196,844

)

(2,258,950

)

 

 

 

 

 

 

 

 

 

 

Interest expense, unrelated parties

 

188,261

 

620,569

 

682,362

 

1,709,430

 

Interest expense, related parties

 

9,460

 

139,256

 

24,523

 

413,559

 

Gain on disposition of assets

 

 

 

(567

)

 

 

 

197,721

 

759,825

 

706,318

 

2,122,989

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(2,347,852

)

$

(1,301,960

)

$

(4,903,162

)

$

(4,381,939

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted loss per share

 

$

(0.14

)

$

(0.17

)

$

(0.29

)

$

(0.57

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

17,198,198

 

7,646,430

 

17,184,127

 

7,636,185

 

 

See accompanying notes to financial statements.

 

2



 

VENDINGDATA CORPORATION

STATEMENTS OF CASH FLOWS

 

(UNAUDITED)

 

 

 

Nine Months Ended September 30,

 

 

 

2004

 

2003

 

 

 

 

 

 

 

Operating activities:

 

 

 

 

 

Net cash used in operating activities

 

$

(8,563,226

)

$

(8,897,624

)

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

Acquisition of intangible assets

 

(4,900

)

(1,022,720

)

Acquisition of plant and equipment

 

(193,043

)

(635,990

)

Acquisition of equipment produced for rental

 

 

(9,500

)

Disposition of equipment produced for rental

 

 

785,600

 

Other

 

665

 

705

 

Deposits

 

 

(204,794

)

Net cash used in investing activities

 

(197,278

)

(1,086,699

)

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

Proceeds from sale of stock

 

 

574,420

 

Reimbursement of offering expense

 

36,731

 

 

Proceeds from leases payable

 

 

989,820

 

Repayment of leases payable

 

(1,731,966

)

(2,110,205

)

Proceeds from notes payable

 

3,250,000

 

400,000

 

Repayment of short-term debt

 

(32,493

)

(384,000

)

Proceeds from convertible debt

 

 

9,050,000

 

Repayment of convertible debt

 

(1,603,077

)

 

Net cash provided by (used in) financing activities

 

(80,805

)

8,520,035

 

 

 

 

 

 

 

Change in cash and cash equivalents:

 

 

 

 

 

Decrease in cash

 

(8,841,309

)

(1,464,288

)

Cash and cash equivalents at beginning of period

 

11,526,664

 

1,778,297

 

Cash and cash equivalents at end of period

 

$

2,685,355

 

$

314,009

 

 

See accompanying notes to financial statements.

 

3



 

VENDINGDATA CORPORATION AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS (UNAUDITED)

 

Note 1—Basis of Presentation

 

The accompanying unaudited financial statements of VendingData Corporation (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions incorporated in Regulation S-B of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair presentation have been included.

 

The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. The accompanying financial statements should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2003, as included in the Company’s Annual Report on Form 10-KSB as filed with the Securities and Exchange Commission from which the accompanying balance sheet information as of that date was derived. Certain reclassifications have been made to amounts presented in prior periods for comparability to the current period presentation.

 

Note 2—Segments

 

The revenue segments identified for geographic region-based enterprise-wide data are as follows: 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September, 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

791,995

 

$

1,856,432

 

$

3,248,356

 

$

5,636,287

 

Asia

 

369,321

 

461,250

 

1,265,378

 

536,250

 

South America

 

 

148,470

 

 

148,470

 

 

4



 

The Company’s revenues, depreciation and operating income distribution by product are as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

SecureDrop®

 

$

106,637

 

$

789,786

 

$

385,412

 

$

2,124,519

 

Shuffler

 

106,947

 

670,409

 

1,148,894

 

2,932,233

 

Deck Checker

 

904,950

 

996,558

 

2,827,111

 

1,224,770

 

Other revenue

 

42,782

 

9,399

 

152,317

 

39,485

 

 

 

$

1,161,316

 

$

2,466,152

 

$

4,513,734

 

$

6,321,007

 

Depreciation and amortization

 

 

 

 

 

 

 

 

 

SecureDrop®

 

$

0

 

$

0

 

$

0

 

$

0

 

Shuffler

 

55,604

 

141,252

 

167,386

 

426,269

 

Deck Checker

 

9,229

 

0

 

23,096

 

0

 

Selling, general and administrative

 

142,331

 

136,250

 

442,663

 

356,184

 

 

 

207,164

 

277,502

 

633,145

 

782,453

 

Operating income (loss)

 

 

 

 

 

 

 

 

 

SecureDrop® gross margin

 

$

61,691

 

$

434,550

 

$

172,068

 

$

1,105,229

 

Shuffler gross margin

 

12,702

 

482,853

 

827,094

 

2,146,459

 

Deck Checker gross margin

 

764,944

 

742,381

 

2,250,348

 

880,070

 

Other cost of goods sold

 

(1,118,699

)

(597,178

)

(2,026,079

)

(1,377,442

)

Selling, general and administrative

 

(1,581,271

)

(1,267,831

)

(4,459,217

)

(4,303,496

)

Research and development

 

(289,498

)

(336,910

)

(961,058

)

(709,770

)

 

 

$

(2,150,131

)

$

(542,135

)

$

(4,196,844

)

$

(2,258,950

)

 

Note 3—Loss per Share (Basic and Diluted)

 

The basic loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding for the period. Loss per share is unchanged on a diluted basis since the assumed exercise of common stock equivalents would have an anti-dilutive effect due to the existence of operating losses.

 

Note 4—Debt

 

The company retired $2,368,077 of convertible debt during the nine months ended September 30, 2004 with cash payments and conversions to common stock.

 

In the quarter ended September 30, 2004, the Company borrowed $3,250,000 in the form of senior notes with non-detachable warrants at a 9% interest rate.  Interest is to be paid semi-annually in arrears, and the principal is due August 15, 2007.

 

Note 5—Options

 

The Company currently has two stock option plans pursuant to which it is authorized to issue options to purchase 3,000,000 shares and 300,000 shares, respectively.  No stock-based employee compensation expense for stock options was reflected in net income for years prior to 2003, as all stock options granted under those plans had an exercise price equal to or greater than the fair market value of the underlying common stock on the date of grant.  Stock-based compensation recorded for the quarter

 

5



 

ended September 30, 2004 and for the nine months ended September 30, 2004 was $30,081 and $44,752, respectively. There were a total of 2,079,380 options outstanding as of September 30, 2004 with an exercise price range between $1.75 and $15.00 and a weighted average exercise price of $3.52.  All stock options have terms not exceeding 10 years.

 

Note 6—Liquidity Issues

 

The Company’s ability to maintain adequate liquidity is dependent upon the success of management’s plans to address and overcome prior operating losses.  Management is updating its 2004 operating plan to increase its sales by expanding its product line and improving its sales efforts both domestically and internationally.  Management has also adopted a program to reduce operating costs through the transfer of manufacturing operations to China and restructuring its service functions to reduce labor and rental expense.  Management focused on financial condition and liquidity improvements through its capital raising efforts in 2003 along with substantial debt reduction and debt conversion.  Through the nine months ended September 30, 2004, the Company remained reliant upon capital from external sources in order to sustain its operations.  The Company believes that it has sufficient liquidity to support its operations until the first quarter of 2005 and that it will be able to secure additional debt or equity capital to meet its needs in 2005.  The Company’s efforts to secure additional financing sources are being impacted by the outcome of the November 29, 2004 hearing on the preliminary injunction sought by a competitor.  An adverse outcome of that hearing would likely impact the cost of and availability of additional financing to the Company.  See Part II - Other Information, Item 1. Legal Proceedings.

 

Note 7—Trade Receivables From Major Customers

 

As of and during the nine months ended September 30, 2004, approximately 2.7% of trade receivables and 5.0 % of total sales and, as of and during the year ended December 31, 2003, approximately 17.6% of trade receivables and 13.3% of total sales were concentrated in the Nevada gaming industry among five customers under common ownership. The Company’s future operations could be affected by adverse changes in the financial condition of, or the Company’s relationships with, the commonly owned Nevada gaming customers, or economic, competitive and political conditions in our customers’ respective local areas or the gaming industry, in general.

 

The Company manages its concentrations of credit risk by evaluating the creditworthiness of customers before credit is extended and monitoring it thereafter. The maximum losses that the Company would incur if a customer failed to pay amounts owed would be limited to the recorded receivables after any allowances provided.

 

Note 8—Contingencies

 

The Company is a party to certain claims, legal actions, and complaints, including a patent infringement action between the Company and one of its main competitors. The Company cannot predict the likely outcome of any such litigation or whether any such substantial litigation would have a material adverse effect on its business as presently conducted or as anticipated.

 

In early February 2004, the State of Nevada initiated a sales/use tax audit of Central Leasing and Madison Leasing, companies through which the Company has obtained lease financing.  As of this filing the State of Nevada has not made a determination if there has been a shortfall in the payment of the sales/use tax. The Company has sold and leased back shufflers and Deck Checkers™ over the last five years.  The auditor for the State of Nevada is trying to determine at what level a sales/use tax needs to be collected.  The Company now collects from our customers in Nevada and remits payments to the State of Nevada.  If the State of Nevada determines that the sales of the products to the leasing companies is the

 

6



 

level at which sales/use tax should have been collected, liability of the leasing companies would be passed to the Company.  The amount of this potential liability could range from a refund of $230,000 to the payment of sales/use tax with interest and penalties of up to $500,000.  The Company intends to defend its position in this matter.

 

The Company is currently involved in litigation involving allegations that its products infringe upon the patents of a competitor.  For additional information, see Part II – Other Information, Item 1. Legal Proceedings.

 

7



 

Item 2.  Management’s Discussion and Analysis or Plan of Operations.

 

Statement on Forward-Looking Information

 

Certain information included herein contains statements that may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, such as statements relating to plans for product development, product placement, capital spending and financing sources.  Such forward-looking information involves important risks and uncertainties that could significantly affect anticipated results in the future and, accordingly, such results may differ from those expressed in any forward-looking statements made herein.  These risks, uncertainties and other factors include, but are not limited to, those relating to our liquidity requirements, our ability to locate necessary sources of capital to sustain our operations, the continued growth of the gaming industry, the success of our product development activities, the acceptance of our products in the marketplace, vigorous competition in the gaming industry, our dependence on existing management, changes in gaming laws and regulations (including actions affecting licensing), our leverage and debt service (including sensitivity to fluctuations in interest rates) and domestic or global economic conditions.

 

For additional discussion of the risks, uncertainties and other factors that may adversely affect our operations, our product acceptance, our competitiveness in the marketplace and our common stock, please see the section entitled, “Risk Factors,” in our Annual Report on Form 10-KSB, as filed with the Securities and Exchange Commission on March 30, 2004.

 

Overview

 

Our strategy is to develop cost-effective niche products for the global gaming industry.  We focus on products that increase the security, productivity and profitability of casino operations.  Our strategy involves marketing certain of our products for sale or lease, depending on the product, the geographic location of the customer and other factors.  We rely on our internal sales staff and distributor relationships for the sale and rental of our products.  Although we anticipate significant sales development and revenue growth, there is no assurance that we will generate sufficient revenue, cash flow or profit to sustain our operations.

 

During the nine months ended September 30, 2004, we have focused on certain steps designed to improve our long-term operations and growth.  These steps included the following:

 

                                          We transferred the Deck Checker™ technology from a third party vendor in Auckland, New Zealand to our China manufacturing facility.

 

                                          We substantially completed the development of our PokerOne™ shuffler and began preliminary prod0uction in our China facility beginning in May 2004.

 

                                          We leased and commenced operations in six additional buildings in our China facility.

 

                                          We transferred research and development for all our table game products to China.

 

                                          We commenced the manufacture of our Deck Checker™ in our China facility.

 

                                          We substantially completed the development of our new RandomPlus™ shuffler.

 

While we have focused on these significant improvements, our sales have been adversely impacted by several factors, including:

 

                                          The effect of pending corporate mergers of major gaming customers on the progression of sales of our SecureDrop™ products.

 

                                          Longer than anticipated approval times from gaming regulatory labs for our Deck Checker™ and PokerOne™ shuffler products.

 

                                          The amount of time and resources that have been spent to transfer significant components of our operations to China.

 

                                          The periods of redundant functions while the transfer of manufacturing and research/development to China has been underway.

 

                                          Delays in completion of our RandomPlus™ shuffler.

 

                                          The development of two additional specialty games for the Macau market which was the beta site for our PokerOne™ shuffler.

 

8



 

Financial Condition

 

Total assets decreased from $24,160,178 to $18,503,654 between December 31, 2003 and September 30, 2004, a decrease of $5,656,524 or 23.4%.  The decrease in total assets was due primarily to the $8,841,309 decrease in cash, offset, in part, by a $1,571,384 increase in inventories, a $1,509,522 increase in trade accounts receivable and a $339,630 increase in prepaid expenses.  The decrease in cash was due to continuing negative operating cash flows and debt reduction.  The primary reason for the increase in trade receivables were the sale of Deck Checkers™ on extended payment terms.  Through the use of cash to increase our inventories of Deck Checker™ units and shufflers, including the PokerOne™ Shuffler, we recognized a net $1,571,384 increase in inventories between December 31, 2003 and September 30, 2004.  The net increase in inventories includes a reserve of $575,446 for obsolete inventories recorded during the three months ended September 30, 2004.  The increased reserve related primarily to our inventories of the Random Ejection Shuffler™ and SecureDrop® systems.

 

Total liabilities decreased by $1,703,627, or 17.2%, from $9,914,953 to $8,211,326 between December 31, 2003 and September 30, 2004.  The decrease in total liabilities was due primarily to a $375,376 decrease in the current portion of our leases payable, a $617,858 decrease in our accounts payable, the elimination of our short-term debt of $2,368,077 through repayment and conversions into common stock and a $1,356,590 decrease in the non-current portion of our leases payable, offset, in part, by the issuance of long-term notes in the original principal amount of $3,250,000.  The decrease in our accounts payable between December 31, 2003 and September 30, 2004 was due primarily due to the final $500,000 payment for the intellectual property rights for the Deck Checker™ and the payment of certain outstanding payables with funds received from the public offering in December of 2003.  The decreases in our leases payable, both current and non-current, was due to the repayment of debt owed on certain equipment leases.

 

During the three months ended September 30, 2004, our management conducted a review of our inventory and determined that there is some impairment of our inventory of Random Ejection Shufflers™ held for rental purposes, as well as related labor and overhead held in inventory.  Additionally, our management determined that our inventory contained certain obsolete parts related to the SecureDrop® Hard Count System.  In view of these findings, our management established a reserve in the amount of $575,446, which was recorded as a charge to cost of goods sold during the three months ended September 30, 2004.  Upon commencement of sales of the RandomPlus™ Shuffler, Our management will review our Random Ejection Shuffler™ inventory and believes that there is a possibility that additional reserves estimated to be in the range between $700,000 and $1,200,000, may be required.  The provisioning of reserves for obsolete inventory will be based primarily on our estimated forecast of product demand and related manufacturing requirements.

 

Critical Accounting Policies and Estimates

 

The following is a summary of what our management believes are the critical accounting policies related to our operations.  The application of these policies, in some cases, requires our management to make subjective judgments regarding the effect of matters that are inherently uncertain.

 

The preparation of financial statements in conformity with generally accepted accounting principles requires our management to make estimates and assumptions that affect reported amounts and disclosures, some of which may require revision in future periods.  Actual results could differ from these estimates.  The following is a summary of what our management believes are the critical accounting policies related to our operations.  The application of these policies, in some cases, requires our

 

9



 

management to make subjective judgments and estimates regarding the effect of matters that are inherently uncertain.

 

Allowance for Doubtful Accounts.

 

In connection with the preparation of our financial statements, management reviews and evaluates the collectibility of our trade receivables and adjusts our allowance for estimated uncollectible accounts as deemed necessary in the circumstances.  These estimates have the potential for critically affecting the determination of results of operations for any given period.  Factors considered by management in making such estimates and adjustments include any concentrations among customers, changes in our relationships therewith, payment history and the apparent financial condition thereof.

 

Revenue Recognition.

 

We recognize revenue from the sale of our products upon installation and functional testing at customer locations because that is when the customer’s obligation becomes fixed and certain pursuant to our standard contracts for the sale of units of the SecureDrop® System, shufflers and Deck Checkers™.  Sales are recognized immediately when shufflers that are rented are converted to purchases depending on the creditworthiness and payment history of the casino company since payment terms are from 20 to 48 months.  The extended warranty and maintenance components that are part of long term sales contracts are unbundled and recognized as deferred revenue amortized over the remaining life of the sales agreement after the initial 90-day warranty as required by the Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables.  The useful life of our shufflers and Deck Checkers™ is five years with proper maintenance; this life can be extended with the replacement of component parts.  If a customer does not possess the required creditworthiness or an established payment history with us, we would then treat this revenue as an installment sale and recognize the associated revenues over time as payments are received.  Revenue from shuffler rentals is recorded at the first of each month in accordance with rental contract terms.  All rental contracts are cancelable upon 30-day written notice by the customer.  Maintenance expense for rental units is recorded in the period it is incurred.  Although sales are not generally made with a right to return, upon occasion, usually associated with the performance warranty, sales returns and allowances are recorded after returned goods are received and inspected.  We provide currently for estimated warranty repair costs associated with sales contracts.  Although there are no extended warranties offered for our products, we do provide for maintenance contracts that are billed and recognized on a monthly basis.

 

Intangible Assets.

 

We have acquired patent rights for various products since 2001 and acquired the patent rights for the Deck Checker™ for $1,004,900 in the third quarter of 2003.  We have estimated an economic useful life of 10 years for the Deck Checker™ patents.  We currently amortize our intangible assets which are related to these patents on a straight-line basis over the estimated useful lives of 10 years.

 

Results of Operations

 

Comparison of Three Months Ended September 30, 2004 and 2003

 

Revenue
 

For the three months ended September 30, 2004, total revenues decreased from $2,466,152 to $1,161,316, compared to the three months ended September 30, 2003, a decrease of $1,304,836 or 52.9%.  The decrease in total revenues was due primarily to decreases in our SecureDrop® and our

 

10



 

shuffler revenue.  We believe that the decreases in revenue were due, in part, to the allocation of resources toward the transfer of certain operations to China, the longer than anticipated approval terms for our new products from gaming regulatory laboratories, the continued development and testing of our new shuffler products, the pending merger transactions involving major U.S. casino operators that have delayed negotiations involving our SecureDrop® products and the delays in discussions with potential international customers.

 

Deck Checker™.  Revenue related to the sale and rental of our Deck Checker™ product decreased 9.2% compared to the three months ended September 30, 2003.  We expect Deck Checker™ revenue to grow as the number of jurisdictions where we can sell the product increases coupled with increased industry acceptance of the product.

 

SecureDrop®.  Our SecureDrop® revenue decreased by 86.5% during the three months ended September 30, 2004 in comparison to the three months ended September 30, 2003.  Although we currently have proposals outstanding for new contracts that may impact revenue in the fourth quarter of 2004, due to the uncertainties related to the ultimate likelihood and timing of the award of these contracts, we believe that we will continue to experience significant fluctuations in SecureDrop® revenue through the end of 2004 and into 2005.

 

Shufflers.  During 2003, we made a strategic decision to offer our customers the choice to either continue renting or to purchase our shufflers for the same monthly payments through long-term sales agreements that range from 24-48 months.  This decision was based on competitive forces in the marketplace and the anticipated introduction of our next generation shufflers in 2004.  As result of this strategic decision, we recorded shuffler sale revenue in the three months ended September 30, 2003 that we were not able to replace in the three months ended September 30, 2004, resulting in a reduction in the number of shufflers currently outstanding on a rental basis.  Accordingly, we experienced a 91.0% decrease in shuffler sales revenue and a 69.6% decrease in shuffler rental revenue during the three months ended September 30, 2004 in comparison to the three months ended September 30, 2003.  Furthermore, due to the continued development and testing of our new RandomPlusÔ and PokerOne™ shufflers, as well as delays in obtaining required regulatory approvals, we were also not able to replace either shuffler sales revenue or rental revenue with revenue from these new shuffler products during the three months ended September 30, 2004.

 

Other Revenues.  Our other revenues for the three months ended September 30, 2004 increased compared to the three months ended September 30, 2003 due to increases in the sale of supplies for SecureDrop® and the Deck Checker™. The upward trend will continue for these consumables as we increase the installed base, particularly Deck Checker™.

 

Cost of Sales
 

 For the three months ended September 30, 2004, our cost of sales increased to $1,440,678, compared to $1,403,546 for the three months ended September 30, 2003, an increase of $37,132 or 2.6%.  The cost of sales for the three months ended September 30, 2004 includes a $575,446 reserve for obsolete inventories.  Although our revenue during the three months ended September 30, 2004 decreased, our costs of sales during the three months ended September 30, 2004 increased primarily due to the aforementioned $575,446 inventory reserve.  The gross margin on revenue for the three months ended September 30, 2004 was a negative $279,362, or a negative 24.1%This compares to a gross margin percentage of $1,062,606, or 43.1%, for the three months ended September 30, 2003 and $990,640, or 48.1%, for the three months ended June 30, 2004.  The decrease in gross margin and gross margin percentage from the same period of the prior year reflects the establishment of a $575,446 reserve for obsolete inventories, the sale of rented shufflers with low depreciated book values during the three months ended September 30, 2003, and the costs incurred during 2004 as we transitioned our manufacturing from Las Vegas to China.  As this transition is completed, we expect improvement in our gross margins in the remainder of 2004 and 2005.  However, as previously noted, management will

 

11



 

continue to evaluate the transition of certain of our products, such as the Random Ejection Shuffler™, which is anticipated to be replaced by the RandomPlus™ shuffler, to determine whether future periods should include additional inventory reserves.

 

Deck Checker™.  The Deck Checker™ cost of goods sold decreased by 114,171, or 44.9%, during the three months ended September 30, 2004.  The decrease was due primarily to a decrease in our Deck Checker™ revenue.  The gross margin percentage on revenue from Deck Checker™ sales revenue was 84.5% during the three months ended September 30, 2004, compared to 74.5% during the three months ended September 30, 2003.  The increase in gross margin percentage was due to the increased sale of Deck Checkers™ manufactured at our China facility during the three months ended September 30, 2004 versus the sale of Deck Checkers™ purchased from a third party manufacturer during the three months ended September 30, 2003.  During the three months ended September 30, 2004, we sold the remaining Deck Checkers™ purchased from this third party manufacturer.  By manufacturing of Deck Checkers™ at our China facility, we anticipate lower costs per unit and an increase in gross margin percentage.

 

SecureDrop®.  Our SecureDrop® cost of goods sold decreased by 87.3% during the quarter ended September 30, 2004 .  The decrease is directly related to the decrease in SecureDrop® sales during the same period.  The gross margin percentage on revenue from SecureDrop® sales revenue was 57.9% in the three months ended September 30, 2004 compared to a gross margin percentage of 55.0% for the three months ended September 30, 2003.

 

Shufflers.  Our shuffler cost of goods sold for the three months ended September 30, 2004 decreased by 94.5% compared to the three months ended September 30, 2003.  The decrease shuffler cost of goods sold was due to the decreased sale of shuffler units during the three months ended September 30, 2004.  The gross margin percentage on revenue from shuffler sales revenue was 54.3% in the three months ended September 30, 2004 compared to 89.8% for the three months ended September 30, 2003.  The conversion of existing rental shufflers with low book values due to depreciation to purchases resulted in an increased gross margin percentage during the three months ended September 30, 2003.

 

The cost of sales and resultant gross margins cited above for the individual products described herein primarily include only material costs.  Associated direct labor and overhead expenses are reported only in aggregate and have not been allocated to individual products.  The allocation of such direct labor and overhead expenses to individual products would have the effect of reducing the gross margin percentages for our products.

 

Selling, General and Administrative Expense
 

For the three months ended September 30, 2004, our selling, general and administrative expenses were $1,581,271, an increase of $313,440, or 24.7%, from $1,267,831 for the three months ended September 30, 2003.  The increase in selling, general and administrative expenses related primarily to increases in consulting and accounting expenses, travel and entertainment expenses, rents, legal and regulatory expenses and other expenses, offset, in part, by decreases in salaries and related costs as a result of reductions in staff.   Included in these expenses was a $293,383 increase in legal and regulatory expenses due the increased investigatory and related gaming compliance costs, the increased costs associated with our financing activities, and the costs associated with our intellectual property litigation.

 

12



 

 

Research and Development Expense
 

For the three months ended September 30, 2004, research and development expenses were $289,498, a decrease of $47,412, or 14.1%, from $336,910 for the three months ended September 30, 2003.  The decrease in research and development expenses was due to the winding down of development costs for the RandomPlus™ and PokerOne™ shufflers incurred in Las Vegas.  Although research and development has been a significant cost, we anticipate that these costs may decrease in the future as a percentage of revenue as more of our research and development functions are being moved to our China facility.

 

Interest Expense

 

For the three months ended September 30, 2004, we incurred interest expenses of $197,721, compared to $759,825 for the three months ended September 30, 2003, a decrease of $562,104 or 74.0%.  This decrease was primarily attributable to the reduced debt service as a result of a decrease in our outstanding indebtedness and the retirement and conversion of $20,331,995 convertible debt in December 2003 and during the three months ended March 31, 2004.

 

Net Loss
 

For the three months ended September 30, 2004, we had a net loss of $2,347,852 compared to a net loss of $1,301,960 for the three months ended September 30, 2003, an increase of $1,045,892, or 80.3%.  The increase in net loss was primarily due to decreases in revenue and increases in operating expenses, including inventory reserves for obsolete inventory, offset, in part, by decreases in interest expenses.  Basic loss per share was $0.14 for the three months ended September 30, 2004, compared to $0.17 for the three months ended September 30, 2003.  Although we experienced increased losses during the three months ended September 30, 2004, the relative decrease in basic loss per share for the three months ended September 30, 2004 was due to the increased number of weighted average shares outstanding during the three months ended September 30, 2004 in light of our public offering of common stock in December 2003 and the conversion of debt into shares of common stock in December 2003 and in the three months ended March 31, 2004.

 

Comparison of Nine Months Ended September 30, 2004 and 2003
 
Revenue
 

For the nine months ended September 30, 2004, our revenues were $4,513,734, compared to $6,321,007 for the nine months ended September 30, 2003, a decrease of $1,807,273, or 28.6%.   The decrease was due primarily to decreases in SecureDrop™ revenue and shuffler revenue, offset, in part, by increases in Deck Checker™ revenue.  We believe that the decreases in revenue were due, in part, to the allocation of resources toward the transfer of certain operations to China, the longer than anticipated approval times for our new products from gaming regulatory laboratories, the continued development and testing of our new shuffler products, the pending merger transactions involving U.S. major casino operators that have delayed negotiations involving our SecureDrop® products and the delays in discussions with potential international customers.

 

Deck Checker™.  Revenue related to the sale and rental of our Deck Checker™ product increased 115.5% for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003.  The significant increase in Deck Checker™ revenue in 2004 was due to the introduction of the Deck Checker™  in the second quarter of 2003.  We expect Deck Checker™ revenue to grow as the number of jurisdictions where we can sell the product increases coupled with increased industry acceptance of the product.

 

13



 

SecureDrop®.  Our SecureDrop® revenue decreased by 81.9% during the nine months ended September 30, 2004 in comparison to the nine months ended September 30, 2003.  The decrease was due to the major installations of SecureDrop® products at properties operated by Caesars Entertainment Inc. during the nine months ended September 30, 2003 and the absence of sufficient sales to replace the revenue generated by these installations. Although we are currently have proposals outstanding for new contracts that may impact revenue in the fourth quarter of 2004, due to the uncertainties related to the ultimate likelihood and timing of the award of these contracts, we believe that we will continue to experience significant fluctuations in SecureDrop® revenue through the end of 2004 and into 2005.

 

 Shufflers.  During 2003, we made a strategic decision to offer our customers the choice to either continue renting or to purchase our shufflers for the same monthly payments through long-term sales agreements that range from 24-48 months.  This decision was based on competitive forces in the marketplace and the anticipated introduction of our next generation shufflers in 2004.  As result of this strategic decision, we recorded shuffler sale revenue in the nine months ended September 30, 2003 that we were not able to replace in the nine months ended September 30, 2004 and reduced the number of shufflers placed on a rental basis.  Accordingly, we experienced a 59.2% decrease in shuffler sales revenue and a 62.2% decrease in shuffler rental revenue during the nine months ended September 30, 2004 in comparison to the nine months ended September 30, 2003.  Furthermore, due to the continued development and testing of our new RandomPlusÔ and PokerOne™ shufflers, as well as delays in obtaining required regulatory approvals, we were also not able to replace either shuffler sales revenue or rental revenue with revenue from these new shuffler products during the nine months ended September 30, 2004.

 

Other Revenues.  Our other revenues for the nine months ended September 30, 2004 increased compared to the nine months ended September 30, 2003 due to increases in the sale of supplies for SecureDrop® and the Deck Checker™. The upward trend will continue for these consumables as we increase the installed base, particularly Deck Checker™.

 

Cost of Sales
 

For the nine months ended September 30, 2004, our cost of sales was $3,290,303, compared to $3,566,691 for the nine months ended September 30, 2003, a decrease of $276,388, or 7.7%.  The cost of sales for the nine months ended September 30, 2004 includes a $575,446 reserve for obsolete inventories recorded in the three months ended September 30, 2004.  Although our revenue during the three months ended September 30, 2004 decreased significantly, our costs of sales during the three months ended September 30, 2004 did not decrease proportionally primarily due to the aforementioned $575,446 inventory reserve recorded during the three months ended September 30, 2004.  The gross margin on revenue for the nine months ended September 30, 2004 was $1,223,431, or 27.1%, compared to the gross margin on revenue for the nine months ended September 30, 2003 of $2,754,316, or 43.6%.  The decrease in gross margin and gross margin percentage from the nine months ended September 30, 2003 to the nine months ended September 30, 2004 reflects a decrease in revenues and an increase in costs of sales during the period, including the $575,446 increase in inventory reserves.  However, as previously noted, management will continue to evaluate the transition of certain of our products, such as the Random Ejection Shuffler™, which is anticipated to be replaced by the RandomPlus™ shuffler, to determine whether future periods should include additional inventory reserves.

 

Deck Checker™.  The Deck Checker™ cost of goods sold increased by $232,693, or 67.5%.  The increase was due primarily to the increase in Deck Checker™ revenue during the nine months ended September 30, 2004.  The gross margin percentage on revenue from Deck Checker™ revenue was 79.6% during the three months ended September 30, 2004, compared to 71.9% during the three months ended

 

14



 

September 30, 2003. The increase in gross margin percentage was due to the increased sale of Deck Checkers™ manufactured at our China facility during the nine months ended September 30, 2004 versus the sale of Deck Checkers™ purchased from a third party manufacturer during the nine months ended September 30, 2003. During the nine months ended September 30, 2004, we sold the remaining Deck Checkers™ purchased from this third party manufacturer. By manufacturing Deck Checkers™ at our China facility, we anticipate lower costs per unit and an increase in gross margin percentage.

 

SecureDrop®.   Our SecureDrop® cost of goods sold decreased by 79.1% during the nine months ended September 30, 2004.  The decrease is directly related to the decrease in SecureDrop® revenue during the same period.  The gross margin percentage on revenue from SecureDrop® sales revenue was 44.6% in the nine months ended September 30, 2004 compared to a gross margin percentage of 52.0% for the nine months ended September 30, 2003.

 

Shufflers.  Our shuffler cost of goods sold for the nine months ended September 30, 2004 decreased by 61.1% compared to the nine months ended September 30, 2003.  The decrease in our shuffler cost of goods sold was due to the decreased sale of shuffler units during the nine months ended September 30, 2004.  The gross margin percentage on revenue from shuffler sales revenue was 83.1% in the nine months ended September 30, 2004 compared to 82.7% for the three months ended September 30, 2003.

 

The cost of sales and resultant gross margins cited above for the individual products described herein primarily include only material costs.  Associated direct labor and overhead expenses are reported only in aggregate and have not been allocated to individual products.  The allocation of such direct labor and overhead expenses to individual products would have the effect of reducing the gross margin percentages for our products.

 

Selling, General and Administrative Expenses
 

For the nine months ended September 30, 2004, our selling, general and administrative expenses were $4,459,217, compared to $4,303,496 for the nine months ended September 30, 2003, an increase of $155,721, or 3.6%.  The slight increase in selling, general and administrative expenses related primarily to increases in consulting and accounting expenses, trade show expenses, repairs and maintenance, legal and regulatory expenses, insurance costs, depreciation expense and finance fees, offset, in part, by decreases in advertising expenses, travel and entertainment expenses, supply costs and other expenses.

 

Research and Development Expense
 

For the nine months ended September 30, 2004, our research and development expenses were $961,058, compared to $709,770 for the nine months ended September 30, 2003, an increase of $251,288, or 35.4%.  The increase was due to expenses incurred as a result of our continued development efforts on the RandomPlus™ and PokerOne shufflers.

 

Interest Expense

 

For the nine months ended September 30, 2004, we incurred interest expense of $706,885, compared to $2,122,989 for the nine months ended September 30, 2003, a decrease of $1,416,104 or 66.7%.  This decrease was primarily attributable to the reduced debt service resulting from the substantial decrease in our outstanding indebtedness and the retirement and conversion into shares of common stock of $20,331,995 convertible debt in December 2003 and in the three months ended March 31, 2004.

 

15



 

Net Loss
 

For the nine months ended September 30, 2004, we had a net loss of $4,903,162, compared to a net loss of $4,381,939 for the nine months ended September 30, 2003, an increase of $521,223, or 11.9%.  The increase in net loss was primarily due to decreases in revenue and increases in operating expenses, including inventory reserves for obsolete inventory, offset, in part, by decreases in interest expenses.  Basic loss per share was $0.29 for the nine months ended September 30, 2004, compared to $0.57 for the nine months ended September 30, 2003.  Although we experienced increased losses during the nine months ended September 30, 2004, the relative decrease in basic loss per share for the nine months ended September 30, 2004 was due to the increased number of weighted average shares outstanding during the nine months ended September 30, 2004 in light of our public offering of common stock in December 2003 and the conversion of debt into shares of common stock in December 2003 and in the three months ended March 31, 2004.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Because of our continued efforts to transition from a development stage company to an operating company, we have generated substantial cash flow deficits from operations, including net cash used in operating activities of $8,563,226 and $8,897,624 for the nine months ended September 30, 2004 and 2003, respectively.  As a result, in order to fund our development and operating activities, we have historically relied upon cash from our financing activities, including $23,047,432 in net cash provided by our financing activities during the twelve months ended December 31, 2003.  During the nine months ended September 30, 2004, our operating activities used net cash of $8,563,226, our investing activities used net cash of $197,278 and our financing activities used net cash of $80,805.  The net cash used in our financing activities consisted of the repayment of $3,367,536 in leases payable, short-term debt and convertible debt and proceeds of $3,250,000 from a private placement of notes.

 

Due to the net cash used in our operating activities, we have been substantially dependent on cash from financing activities to fund our development and operating activities.  We will continue to require cash from financing activities for our current operating needs until our operations generate sufficient cash flow to provide for such cash requirements.  Our management believes that we will continue to be dependent upon our financing activities to sustain our operations in the near term.

 

Sources of Capital
 

In addition to our cash on hand and the cash to be generated from our operations, we anticipate relying upon private and institutional sources of debt and equity.  During the years ended December 31, 2003 and 2002, our sources of capital included common stock offerings, equipment financing from a third party, short-term notes from stockholders, convertible debentures and other private sources of capital.

 

With respect to common stock offerings, we received proceeds of $25,415,504, $0 and $4,169,092 during the years ended December 31, 2003, 2002 and 2001, respectively.

 

With respect to equipment financing, we have sold and leased back most of our furniture, equipment, tooling and shufflers held for rent.  During the years ended December 31, 2003, 2002 and 2001, we received proceeds of $989,820, $2,988,385 and $1,335,306, respectively, from equipment financing.  During the years ended December 31, 2003, 2002 and 2001, we repaid equipment financing of $2,754,607, $2,823,331 and $1,824,118, respectively.  As of September 30, 2004, we had outstanding equipment financing of $2,421,830.  These equipment leases have terms of 36 to 39 months and were not recorded as sales because each of the leases included a mandatory buy-back provision.

 

16



 

With respect to short-term notes from stockholders, we received proceeds of $700,000, $2,264,871 and $4,029,402 during the years ended December 31, 2003, 2002 and 2001, respectively.  Conversely, we repaid short-term notes from stockholders in the amounts of $1,310,000, $650,000 and $563,400 during the years ended December 31, 2003, 2002 and 2001, respectively.  As of September 30, 2004, we had outstanding short-term loans in the aggregate amount of $238,250.  Prior to 2003, we were substantially dependent on short-term loans from our principal stockholder and other directors.  Despite such reliance, neither our principal stockholder nor our directors are obligated to provide additional financing to us, and our principal stockholder and directors are free to decline to fund additional financings to us at any time.  In such event and in the absence of other third party financing sources, we would most likely have substantial difficulty in raising additional financings.

 

With respect to convertible debentures, we received proceeds of $11,050,000, $4,903,076 and $0 from the placement of convertible debentures during the years ended December 31, 2003, 2002 and 2001, respectively.  Conversely, we have repaid convertible debentures in the amounts of $11,019,285, $0 and $0 during the years ended December 31, 2003, 2002 and 2001, respectively.  We have completely retired the convertible debentures during the three months ended March 31, 2004.

 

Outlook
 

Our ability to maintain adequate liquidity is substantially dependent upon the success of management’s plans to address and overcome prior operating losses. Management is updating its 2004 operating plan to increase our sales by expanding our product line and improving our sales efforts both domestically and internationally.  Although we have continued to generate revenue from our products during the year ended December 31, 2003 and the nine months ended September 30, 2004, we continue to struggle with the placement of our products throughout the gaming industry.  We believe that certain  2004 potential sales that would have generated cash were delayed, in part, due to pending merger transactions involving major U.S. casino operators that have delayed negotiations involving our SecureDrop® products as well as delays in discussions with potential international customers.  The degree of market acceptance for our products will depend upon a variety of factors, including the effectiveness and reliability of our products, the continued approvals for our products from gaming jurisdictions, the success of our marketing and distribution strategies and the level of customer satisfaction.  In addition to our sales initiatives, our management has adopted efforts to reduce operating costs through the transfer of manufacturing operations to China and restructuring our service functions.

 

Until we can generate sufficient cash from operations to support our business, we will need to raise additional cash from private placements of debt or equity or from lease financing sources.  In the event that such sources are insufficient or unavailable, we will need to seek cash from public or private placements of debt or equity, institutional or other lending sources, sell certain assets or change operating plans to accommodate such liquidity issues.  No assurances can be given that we will successfully obtain liquidity sources necessary to fund our operations in the upcoming year.  If we continue to generate significant losses from our operations and we are not able to located additional sources of liquidity, we may be unable to continue as a going concern.  Through the nine months ended September 30, 2004, we remained reliant upon capital from external sources in order to sustain its operations.  We believe that we have sufficient liquidity to support our operations until the first quarter of 2005 and that we will be able to secure additional debt or equity capital to meet our needs in 2005.  Although at a cost higher than other sources, we have access to up to $3,000,000 in lease financing as a potential source of liquidity should we need to draw on it.   Our efforts to secure additional financing sources are also being impacted by the outcome of the November 29, 2004 hearing on the preliminary injunction sought by a competitor.  An adverse outcome of that hearing would likely impact the cost of and availability of additional financing to us.  See Part II — Other Information, Item 1. Legal Proceedings, below.

 

17



 

ITEM 3.                             CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls.  We evaluated the effectiveness of our disclosure controls and procedures as of the end of the three months ended September 30, 2004.  This evaluation was done with the participation of Steven J. Blad, our chief executive officer, Douglas H. Caszatt, our acting chief financial officer, and Philip F. Otto, an independent consultant retained by us in October 2004 to assist us in, among other things, reviewing our disclosure controls and procedures.  Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, as appropriate to allow timely decisions regarding required disclosure.

 

Our management does not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent all error and all fraud.  A control system, no matter how well conceived and operated, can provide only reasonable, but not absolute, assurance that the objectives of a control system are met.  Further, any control system reflects limitations on resources, and the benefits of a control system must be considered relative to its costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of a control.  The design of a control system is also based upon certain assumptions about the likelihood of future events, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

 

Based on this evaluation, we concluded that, subject to the limitations noted above, our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

 

Changes in Internal Control Over Financial Reporting.  Although there have been no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, we are continuously evaluating means of enhancing our internal controls.  In this regard, in October 2004 we engaged Philip F. Otto as an independent consultant to provide financial advisory and related services, including a review our financial systems, a review of our corporate governance procedures and the preparation of business plans, financial models, and presentations.  Most recently, Mr. Otto has provided financial, strategic and merger and acquisition advisory services to technology companies. Mr. Otto has also recently served as Chief Financial Officer, Chief Executive Officer and director of MedioStream, Inc, managing its operations in both Silicon Valley and Shanghai. From 1992 to1997, Mr. Otto was chairman and chief executive officer of NASDAQ-listed California Microwave, Inc.

 

18



 

PART II – OTHER INFORMATION

 

ITEM 1.  LEGAL PROCEEDINGS.

 

On March 27, 2002, Shuffle Master, Inc., or Shuffle Master, filed a complaint (Case No. CV-S-02-0438-JCM-PAL) against VendingData in the United States District Court, District of Nevada.  The amended complaint alleges, among other things, claims for patent infringement and requests treble damages, an injunction enjoining us from infringing on two of Shuffle Master’s patents, an accounting of our gains and profits that resulted from the alleged infringement, and for interest, costs and attorneys’ fees.  The Shuffle Master patents that are at issue in the litigation concern registering use of a playing card shuffler apparatus and the displaying of the use on a display.  We have filed our answer, counterclaims, and amended counterclaims against Shuffle Master.  In the answer, we deny Shuffle Master’s allegation of patent infringement and request that Shuffle Master’s complaint be dismissed.  We also seek, in our amended counterclaim, a declaration that we do not infringe Shuffle Master’s patents and that Shuffle Master’s patents and certain of its related claims are invalid.  We further assert counterclaims against Shuffle Master for breach of contract and violation of the Uniform Trade Secrets Act.  On May 20, 2002, the United States District Court, District of Nevada denied Shuffle Master’s motion for preliminary injunction against us.  Discovery in this litigation is now closed.  On May 28, 2003, we filed a motion for summary judgment.  The hearing on this motion for summary judgment was taken off calendar pending a ruling from the Court regarding claim construction to determine the scope and definition of the patent claims at issue.  On March 31, 2004, the Magistrate Judge issued an order with regard to claim interpretation, to which we have filed written objections.  On June 25, 2004, the District Court affirmed the Magistrate Judge’s order.  On August 24, 2004, we renewed our motion for summary judgment to invalidate Shuffle Master’s patents, United States Patent Nos. 6,325,373 (“‘373”) and 6,068,258 (“‘258”), which cover card moving mechanisms that regulate use of the shuffler apparatus.  On October 14, 2004, the District Court issued an order denying the motion for summary judgment for failure to submit admissible evidence in support of the motion for summary judgment.  We filed a motion for clarification and reconsideration of the Court’s order on November 5, 2004 in order to have the underlying merits of our motion for summary judgment considered.  No decision has yet been reached on this motion.

 

On October 5, 2004, Shuffle Master filed another patent infringement action against us in the United States District Court, District of Nevada (Case No. CV-S-04-1373-JCM-LRL).  Shuffle Master alleges that the use, importation and offering for sale of the PokerOne™ shuffler infringes Shuffle Master’s United States Patent No. 6,655,684.  On October 25, 2004, we filed our answer and counterclaim that denies Shuffle Master’s allegations of patent infringement and requests that the Court enter a declaratory judgment of non-infringement.  The United States Patent and Trademark Office, on March 14, 2004, issued to us patent number 490,481 for the PokerOne™ shuffler.  We are offering the PokerOne™ for sale in the United States consistent with the patent issued by the United States Patent and Trademark Office.  On October 14, 2004 Shuffle Master filed a Motion for Preliminary Injunction seeking to enjoin us from selling the PokerOne™ shuffler in the United States during the pendency of its second lawsuit.  A court hearing on the preliminary injunction request will be held on November 29, 2004.

 

ITEM 2.  CHANGES IN SECURITIES.

 

Common Stock Offering.  On December 18, 2003, we completed a public offering of 5,500,000 shares of our common stock.  The placement agent for the offering was Philadelphia Brokerage Corporation.  Our shares of common stock sold in the offering were registered under the Securities Act in a Registration Statement on Form SB-2, as amended (File No. 333-109115), or the Registration Statement.  The Securities and Exchange Commission declared the Registration Statement effective on December 11, 2003.

 

19



 

The public offering price was $5.00 per share for an aggregate sales price of $27,500,000.  We paid commissions of $1,925,000 to our placement agent, a non-accountable expense allowance of $25,000 to our placement agent and offering expenses of approximately $750,000.  None of the expenses related to the initial public offering were paid directly or indirectly to any of our directors, officers, general partners or their associates, or to any persons owning 10% or more of any class of our equity securities, or to any of our affiliates.  We received net proceeds from the public offering of approximately $24,800,000 after deducting the underwriting discounts and commissions and the offering expenses.

 

From the effective date of the Registration Statement through the nine months ended September 30, 2004, we have used all of the $24,800,000 of net proceeds from the public offering as follows:

 

USE OF PROCEEDS TO DATE

 

AMOUNT

 

Retirement of loan from Mellon Bank HBV SPV, LLC

 

$

2,775,000

 

Retirement of loan from Triage Capital Management LP

 

850,000

 

Retirement of loan from Triage Offshore Fund, Ltd.

 

1,000,000

 

Retirement of loan from LC Capital Master Fund, Ltd.

 

1,000,000

 

Retirement of a portion of 10% convertible senior notes

 

7,100,000

 

Repayment of convertible senior notes

 

1,600,000

 

Lease payments

 

1,200,000

 

Funding to increase product inventory

 

1,500,000

 

Purchase of fixed assets

 

160,000

 

Payment of operating expenses

 

7,615,000

 

TOTAL

 

$

24,800,000

 

 

Debt Private Placement.  On September 21, 2004, we received debt financing in the amount of $3,250,000 through a private placement of senior notes and warrants.  Philadelphia Brokerage Corporation, the placement agent for the private placement, received a 4% commission totaling $130,000.  The private placement consisted of units, where each unit consisted of a 9% senior note in the original principal amount of $25,000 and a warrant to purchase 1,500 shares of our common stock.  We sold 130 units representing 9% senior notes in the original principal amount of $3,250,000 and warrants to purchase 195,000 shares of our common stock.  The warrants have an exercise price of $5.00 per share and must be exercised before August 15, 2009.  The private placement terminated November 1, 2004.

 

The proposed uses for the private placement proceeds are for product build kits, tooling and manufacturing, product development and working capital.  The units were not registered pursuant to the Securities Act but were offered pursuant to the exemption from registration provided by Rule 506 of Regulation D of the Securities Act.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

 

Not applicable.

 

20



 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

On October 5, 2004, we held our Annual Meeting of Stockholders at which the following matters were voted on and approved by our stockholders:

 

1.             Election of four directors for terms expiring in 2005:

 

 

 

For

 

Against/Withheld

 

 

 

 

 

 

 

Steven J. Blad

 

13,773,289

 

2,029,600

 

James E. Crabbe

 

15,703,489

 

99,400

 

Ronald O. Keil

 

15,704,289

 

98,600

 

Bob L. Smith

 

15,704,289

 

98,600

 

 

2.                                       Amendment to our 1999 Directors’ Stock Option Plan increasing the number of shares reserved thereunder from 20,000 shares to 300,000 shares:

 

For

 

11,110,877

 

Against

 

416,244

 

Abstain

 

12,814

 

 

3.                                       Amendment to our 1999 Stock Option Plan increasing the number of shares reserved thereunder from 2,000,000 shares to 3,000,000 shares:

 

For

 

11,112,077

 

Against

 

424,444

 

Abstain

 

3,414

 

 

4.                                       Ratification of the appointment of Piercy Bowler Taylor & Kern, as our independent auditors, for the fiscal year ending December 31, 2004:

 

For

 

15,706,389

 

Against

 

91,500

 

Abstain

 

5,000

 

 

ITEM 5.  OTHER INFORMATION.

 

Not applicable.

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

 

(a)           Exhibits.

 

10.1                           Form of Promissory Note for 2004 Note Placement

 

10.2                           Form of Warrant for 2004 Note Placement

 

10.3                           Form of Security Agreement for 2004 Note Placement

 

31.1                           Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.2                           Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

21



 

32.1                           Certification of President and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).

 

(b)           Reports on Form 8-K.

 

During the three months ended September 30, 2004, we filed the following:

 

                                          Current Report on Form 8-K filed on August 9, 2004 reporting the issuance of a press release announcing our financial results for the period ended June 30, 2004;

 

                                          Current Report on Form 8-K filed on September 22, 2004 disclosing materials provided at the Merriman Curhan Ford Investor Summit 2004 on Tuesday, September 21, 2004; and

 

                                          Current Report on Form 8-K filed on September 24, 2004 reporting the receipt of debt financing in the original principal amount of $3,250,000 and the issuance of warrants to purchase an aggregate of 195,000 shares of our common stock.

 

22



 

SIGNATURE

 

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

 

VENDINGDATA CORPORATION

 

 

(Registrant)

 

 

 

 

Date:

November 15, 2004

By:

 /s/ Steven J. Blad

 

 

 

 

 Steven J. Blad

 

 

Its:

 Chief Executive Officer and President
 (Principal Executive Officer and Duly
 Authorized Officer)

 

23