[August 26, 2011] BALLY TECHNOLOGIES, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Business Overview We are a diversified, worldwide gaming company that innovates, designs, manufactures, operates and distributes advanced technology-based gaming devices, systems and server-based solutions. As a global gaming-systems provider, we offer technology solutions which provide gaming operators with a wide range of marketing, data management and analysis, accounting, player tracking, security and other software applications and tools to more effectively manage their operations. Our primary hardware technologies include spinning-reel and video gaming devices, specialty gaming devices and wide-area progressive systems for traditional land-based, riverboat and Native American casinos, video lottery and central determination markets and specialized system-based hardware products. We previously owned and operated the Rainbow Casino, a dockside riverboat casino in Vicksburg, Mississippi. On April 5, 2010, we entered into a definitive purchase agreement to sell the Rainbow Casino. The sale closed on June 8, 2010. As a result of the sale, our Casino Operations were classified as discontinued operations in the accompanying financial statements. See Note 3 to the consolidated financial statements, Discontinued Operations. We derive our revenues from the following: • Gaming Equipment - Sale of gaming devices and related equipment, parts and conversion kits; • Gaming Operations - Operation of linked progressive systems, video lottery and centrally determined systems and the rental of gaming devices and content; and • Systems - Sale and support of specialized systems-based software and hardware products and related recurring hardware and software maintenance revenue. We review certain financial measures in assessing our financial condition and operating performance not only in connection with creating our forecasts and in making comparisons to financial results from prior periods, but also in making comparisons to our competitors' financial results and our internal financial plans. We focus on fluctuations in revenue, cost and gross margin and also pay close attention to changes in our consolidated operating income, net income, diluted earnings per share, Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization, including asset charges and share-based compensation), cash flows from operations and free cash flow (cash flows from operating activities less capital expenditures) as they are key indicators of our success. We also measure changes in selling, general and administrative ("SG&A") expenses as a percent of revenue, which indicate management's ability to control costs, as well as changes in research and development ("R&D") costs as a percent of revenue, which demonstrate our investment in technology and product development. The measures listed above are not a comprehensive list of all factors considered by us in assessing our financial condition and operating performance, and we may consider other individual measures as required by trends and discrete events arising in a specific period, but they are the key indicators. We are currently operating in a challenging economic environment. The combination of economic uncertainty, lower demand for replacement products and reduced opportunities from new or expanded markets has negatively impacted the gaming sector and our consolidated results. The gaming sector was and continues to be negatively impacted by lower consumer spending. As a result of the challenging economic environment, we have provided select customers a greater amount of payment terms for periods up to one year, and in some cases for periods up to three years. We expect to continue to extended credit for these longer periods for the foreseeable future. Our operating results for fiscal year 2011and fiscal year 2010 reflect the continued tough economic conditions currently facing the gaming industry, which has resulted in a slow domestic replacement 34 -------------------------------------------------------------------------------- cycle and a lower number of casino openings and expansions, combined with lower system revenues in fiscal year 2011 resulting from the timing of implementations and longer than expected customer decision making cycles. Game equipment revenues were $246.6 million, $273.7 million and $357.0 million for the years ended June 30, 2011, 2010 and 2009, respectively. The decrease in revenue reflects the lower number of new casino openings and expansions in fiscal year 2011 combined with a slow domestic replacement cycle. During the years ended June 30, 2011, 2010 and 2009, we sold 9,552, 10,813 and 16,848 new gaming devices in the United States and Canada, respectively, of which 8,455, 8,911 and 13,032, were replacement units, respectively. In calendar year 2010, we released our new Pro Series cabinets with ALPHA 2 technology which are state of the art for the industry with regards to ergonomics, processing power, display technology, input device, operating system, sound and serviceability. This new platform allows us to develop new, more compelling games and also facilitates our game download solution for customers. The majority of our Pro Series cabinets feature our latest innovation, iDeck, an LCD (liquid crystal display) touch screen that replaces the traditional button panel and OLED's (Organic light-emitting diodes). iDeck is the first of its kind multi-touch fully programmable and downloadable button panel which offers opportunity to add more interaction to the game-play experience with mystery bonus events, virtual shooting galleries and skill-based bonus games. Systems revenues were $193.0 million, $217.5 million and $211.8 million for the years ended June 30, 2011, 2010 and 2009, respectively. Systems revenues were negatively impacted by the timing of certain customer decisions regarding system purchases and upgrades which impacted implementation timelines during fiscal year 2011. Maintenance revenue increased 12% in the year ended June 30, 2011, when compared to the same period last year, as a result of an increased install base of customers utilizing our systems. Even though systems sales were negatively impacted by customers delaying purchases due to the prolonged, challenging economic environment, the new SDS Version 11, which runs on both Unix and Windows using the same code base, our iVIEW DM and our Elite Bonusing Suite are generating positive interest. We recently announced an enterprise-wide agreement with one of the world's largest casino entertainment companies to implement iView DM player-user-interfaces across their casino operations. Despite the challenging economic conditions, we have continued to invest in the basics of enterprise software development, delivery, customer support and services discipline, on improving core products, providing quality upgrade options for our customers, and increasing customer satisfaction levels through better service and support which are all serving us well in these difficult economic times. Despite the prolonged, challenging economic conditions and the absence of revenue from the charitable bingo market in Alabama, (see Note 4 to the consolidated financial statements, Impairment Charges), gaming operations revenues continued to increase at $318.6 million, $287.0 million and $275.0 million during the years ended June 30, 2011, 2010 and 2009, respectively. Revenues were stronger year over year due primarily to the continued performance of existing and new premium game titles which increased rental and participation revenue, and increases in our centrally determined business. We experienced significant growth in the installed base of our rental and daily-fee games which increased by approximately 1,121 units over June 30, 2010. Fiscal year 2011 results benefitted from our growing product offerings and innovations, such as U-Spin, our first in a series of play mechanics utilizing gesture control, and the continued success of our Cash Spin game, Digital Tower Series platforms and Hot Shot family of games. We also introduced the first dual wheel game with Vegas Hits in addition to the release of Cash Wizard, our first Alpha 2 premium game with a spinning wheel bonus. In the fourth quarter of fiscal year 2011, we released our first Hammer Head products to our wide-area progressive game lineup and also introduced a follow-up to Cash Spin called Hot Spin, where the player can choose the symbol and thereby the frequency of the bonus wheel feature. Additionally, we introduced Betty Boop Love Meter, a wide-area progressive game. We continue to focus our 35 -------------------------------------------------------------------------------- development efforts on the introduction of new and innovative games and cabinets both for our spinning-reel and video platforms. International revenues were $138.9 million, $157.0 million and $141.9 million for the years ended June 30, 2011, 2010 and 2009, respectively. International revenues decreased in fiscal year 2011, when compared to the same period last year, due primarily to a decrease in sales in Mexico, and Asia, which was slightly offset by increases in sales in South America during the same period. We continue to focus on international expansion opportunities and began selling our games in Australia in the fourth quarter of fiscal year 2011. In addition, we are testing with the Italian regulatory authorities and expect we will be approved to place gaming machines in the market in the first half of fiscal year 2012. There are several new and potential gaming market developments that we believe will benefit us in the long term. In North America, we are focused on approved new jurisdictional opportunities and expansions in Canada, Illinois, Ohio, New York, Kansas, Maryland, New Jersey, Louisiana, Mississippi and California, and the potential for new market opportunities in Massachusetts, Minnesota, Michigan, Maine and Texas. The breadth and timing of such opportunities remain uncertain due to the legislative process in these jurisdictions, as well as the difficult credit environment facing certain of our customers and the risk of the gaming industry impact of continued economic uncertainty. We are also engaged in expanding our position in South Africa, Australia, New Zealand, and Mexico, as it continues to move towards Class III gaming, and, in the future, we also expect to generate revenue from the new Italian VLT market and from potential new markets in Eastern Europe, Africa, Greece, Taiwan, Korea, and Brazil. Further, as we continue to grow and gain market share in Asia, opportunities are anticipated to arise in that region which would enable us to further expand internationally. Net cash provided by operating activities from continuing operations was $56.8 million, $129.1 million and $153.3 million for the years ended June 30, 2011, 2010 and 2009, respectively. Cash flows provided by operating activities from continuing operations in the current period were negatively impacted by our investment in inventories to significantly expand our installed base of leased gaming equipment and to build games for the new market opportunity in Italy and, to a lesser extent, a reduction in income from continuing operations. In addition, during fiscal year 2010, we recorded impairment charges of $11.4 million related to our exit from the charitable bingo gaming market in Alabama. On April 8, 2011, we launched a modified Dutch auction tender offer to purchase up to $400 million of our common stock. On May 12, 2011, we purchased 9.9 million shares of our common stock under the tender offer at $40.18 per share for $398.3 million. On April 15, 2011, we entered into an amended and restated credit agreement that provided for a $700 million senior secured credit facility comprised of a $300 million, five-year term loan and a $400 million, five-year revolving credit facility. We utilized proceeds from the amendment and restatements of the credit facility to fund the shares repurchased under the tender offer. During fiscal year 2011, in addition to the 9.9 million shares purchased under the tender offer, we purchased 2.0 million shares of our common stock for approximately $75.7 million. Management continuously monitors and reviews its SG&A expenses in comparison to revenues. SG&A expenses from continuing operations increased to $225.0 million from $203.2 million during the years ended June 30, 2011 and 2010, respectively. SG&A expenses from continuing operations increased as a percentage of revenue to 30% during the year ended June 30, 2011, compared to 26% and 25% during the years ended June 30, 2010 and 2009, respectively. The increase in SG&A expenses as a percentage of revenue during the year ended June 30, 2011 was due primarily to the decrease in revenue during the current period coupled with increases in payroll and related expenses, legal fees, travel and entertainment and bad debt expense, which were offset by decreases in outside services and temporary labor during the same periods. The increase in SG&A expenditures for legal fees and travel and entertainment reflect our investment in potential new markets. 36 -------------------------------------------------------------------------------- Results of Operations The summary financial results and operating statistics are as follows: Year Ended June 30, 2011 % Rev 2010 % Rev 2009 % Rev (dollars in millions) Revenues Gaming Equipment $ 246.6 33 % $ 273.7 35 % $ 357.0 42 % Gaming Operations 318.6 42 % 287.0 37 % 275.0 33 % Systems 193.0 25 % 217.5 28 % 211.8 25 % Total revenues $ 758.2 100 % $ 778.2 100 % $ 843.8 100 % Gross Margin Gaming Equipment(1) $ 112.1 45 % $ 138.0 50 % $ 166.8 47 % Gaming Operations 229.8 72 % 203.9 71 % 194.9 71 % Systems(1) 142.6 74 % 156.5 72 % 150.2 71 % Total gross margin $ 484.5 64 % $ 498.4 64 % $ 511.9 61 % Selling, general and administrative 225.0 30 % 203.2 26 % 212.7 25 % Research and development costs 88.1 12 % 80.3 10 % 77.3 9 % Impairment charges - - 11.4 1 % - - Depreciation and amortization 19.9 3 % 19.4 3 % 18.9 2 % Operating income $ 151.5 20 % $ 184.1 24 % $ 203.0 24 % Income from continuing operations $ 98.2 13 % $ 110.1 14 % $ 120.2 14 % -------------------------------------------------------------------------------- º (1) º Gross Margin from Gaming Equipment and Systems excludes amortization related to certain intangibles, including core technology and license rights, which are included in depreciation and amortization. Year Ended June 30, 2011 2010 2009 Operating Statistics: New gaming devices 13,537 17,334 22,108 New unit Average Selling Price ("ASP") $ 15,832 $ 14,398 $ 14,259 End of period installed base: Gaming monitoring units installed base 407,000 386,000 362,000 Linked progressive systems 1,059 1,030 1,010 Rental and daily-fee games 14, 315 13,194 11,592 Video lottery systems 8,350 7,739 8,152 Centrally determined systems 50,754 50,029 48,924 Fiscal Year 2011 vs. Fiscal Year 2010 Total revenues decreased $20.0 million, or 3%, in fiscal year 2011, when compared to fiscal year 2010, as a result of the following: Gaming Equipment Revenue. Gaming Equipment revenue decreased by $27.1 million, or 10%, to approximately $246.6 million primarily as a result of a 22% decrease in new gaming device sales to 13,537 units in fiscal year 2011. New gaming device sales decreased due to a challenging economy, lower international sales and a continued sluggish North America replacement market and fewer new 37 -------------------------------------------------------------------------------- casino openings and expansions during this period as compared to the same period last year. ASP of new gaming devices increased by 10% to $15,832 in fiscal year 2011 compared to $14,398 in the same period last year. The increase in ASP was primarily as a result of the mix of products sold including sales of the new Pro Series cabinets with Alpha 2 technology in the current fiscal year which made up approximately 47% of shipments. Gaming Equipment Gross Margin. Gaming Equipment gross margin decreased to 45% in fiscal year 2011 from 50%, in the same period last year, due primarily to the write-down of older technology platforms, an increase in royalty-based fees associated with third-party themes due to an increase in the number of related unit and game conversion kit sales, and the increased cost of our new Pro Series cabinets during the current period. Gaming Operations Revenue. Gaming Operations revenue increased $31.6 million, or 11%, to approximately $318.6 million in fiscal year 2011, when compared to the same period last year, primarily as a result of an increase in participation and rental revenue and the placements of higher yield premium products, including Cash Spin and Vegas Hits, the performance of our lottery systems installed base, as well as the continued success of our Digital Tower Series and Hot Shot family of games. The improvement in participation and rental revenue was primarily due to increases in our end of period installed base of games, that included an 8% increase in the installed games base of rental and daily fee games from 13,194 games as of June 30, 2010 to 14,315 games as of June 30, 2011. Gaming Operations Gross Margin. Gross margin increased to 72% in fiscal year 2011 from 71% in fiscal year 2010. The improvement in gross margin was primarily due to increases in participation revenue which had little associated variable costs. Systems Revenue. Systems revenue decreased $24.5 million, or 11%, to approximately $193.0 million in fiscal year 2011, when compared to the same period last year, due primarily to the timing of certain customer decisions regarding system purchases and upgrades which impacted the closing of deals and implementation timelines. Maintenance revenue increased 12% in fiscal year 2011, when compared to the same period last year, as a result of the increased installed base of customers on our systems. During fiscal year 2011, increases in maintenance revenue were offset by a 30% decrease in software and services revenue and a 10% decrease in hardware revenue, when compared to the same period last year. Systems Gross Margin. Systems gross margin increased to 74% in fiscal year 2011 from 72%, in the same period last year, primarily as a result of a change in the mix of products sold in the comparative periods coupled with an increase in maintenance revenue which involves minimal variable costs during the same period. Specifically, Systems revenues for fiscal year 2011 were comprised of 39% hardware, 34% maintenance and 27% software and service revenue, as compared to 38% hardware, 27% maintenance and 35% software and services revenue in the same period last year. Selling, General and Administrative Expenses. SG&A expenses increased $21.8 million, or 11%, in fiscal year 2011, when compared to the same period last year, due primarily to increases in payroll and related expenses, legal fees, travel and entertainment expense and bad debt expense. Payroll and related expenses increased due primarily to an 8% increase in headcount in the comparative periods as a result of our expansion into international markets. Legal fees increased due primarily to costs associated with recent litigation and fees related to our entrance into new international markets. The increase in travel and entertainment expense was due primarily for travel associated with new business and the addition of new international locations. Bad debt expense increased due primarily to increases in accounts receivable during the comparable periods and the increased exposure to international markets. Bad debt as a percentage of revenue continues to remain at approximately 1%. 38 -------------------------------------------------------------------------------- Research and Development Costs. R&D costs increased $7.8 million, or 10%, in fiscal year 2011, when compared to the same period last year, due primarily to an increase in employees and an increase in hardware development costs. The increased costs are attributable to our continued focus on our technology assets due to the increased focus on content development on the ALPHA 2 platform and the new Pro Series cabinets as well as development of iVIEW DM. Impairment Charges. Impairment charges of $11.4 million were recorded during fiscal year 2010 due to the circumstances in Alabama where the legality of charitable bingo gaming was under challenge by the state's governor and there were several lawsuits pending before the State's Supreme Court that negatively affected charitable gaming in the state. See Note 4 to the consolidated financial statements, Impairment Charges. Depreciation and Amortization Expense. Depreciation and amortization expense increased $0.5 million, or 3%, in fiscal year 2011, when compared to same period last year, primarily as a result of additions of leased gaming equipment year over year. Fiscal Year 2010 vs. Fiscal Year 2009 Total revenues decreased $65.6 million, or 8%, in fiscal year 2010, when compared to fiscal year 2009, as a result of the following: Gaming Equipment Revenue. Gaming Equipment revenue decreased by $83.3 million, or 23%, to approximately $273.7 million primarily as a result of a 22% decrease in new gaming device sales to 17,334 units in fiscal year 2010. New gaming device sales decreased due to a sluggish North America replacement market and fewer new casino openings and expansions during this period as compared to the same period in the prior fiscal year. Further, during fiscal year 2010, trade-in allowances and customer discounts increased $8.2 million and parts revenues decreased $7.8 million, when compared to the same period in fiscal year 2009. ASP increased slightly by 1% to $14,398 in fiscal year 2010 compared to $14,259 in the same period in fiscal year 2009. The increase in ASP was primarily as a result of the mix of newer and higher priced platforms sold during the fiscal year 2010, when compared to the same period in the prior fiscal year. Used games revenue increased $3.9 million during fiscal year 2010 due primarily to the greater number of older, used premium platforms sold at a higher ASP, when compared to the same period in fiscal year 2009. Gaming Equipment Gross Margin. Gaming Equipment gross margin increased to 50% in fiscal year 2010 from 47%, in the same period in the prior fiscal year, primarily as a result of product mix and improved purchasing and manufacturing efficiencies. In addition, royalty expense decreased $7.9 million in fiscal year 2010 when compared to the same period in fiscal year 2009, due to a reduction in fees associated with unit sales and game conversion kits with third party titles. There was also a $1.8 million decrease in inventory write-downs during the same period as a result of improved material planning efforts and a concentrated effort to convert or rework slower moving inventory, when compared to the same period in the prior fiscal year. Gaming Operations Revenue. Gaming Operations revenue increased $12.0 million, or 4%, to approximately $287.0 million in fiscal year 2010, when compared to the same period in fiscal year 2009, primarily as a result of an increase in participation, rental and license revenue. The improvement in participation revenue was primarily due to higher lottery revenue due to an increase in rates and net win per unit during the period, as well as an increase in premium revenue units. The improvement in rental revenue was due the 14% increase in the installed games base from 11,592 games as of June 30, 2009 to 13,194 games as of June 30, 2010. Gaming Operations Gross Margin. Gross margin was consistent at 71% in both fiscal years 2010 and 2009. 39 -------------------------------------------------------------------------------- Systems Revenue. Systems revenue increased $5.7 million, or 3%, to approximately $217.5 million in fiscal year 2010, when compared to the same period in fiscal year 2009, primarily as a result of an increase in maintenance revenue during the period. Maintenance revenue increased 14% in fiscal year 2010, when compared to the same period in the prior fiscal year, as a result of the increased installed base of customers on our systems. In addition, during fiscal year 2010, there was a 12% increase in software and services revenue, which was offset by a decrease of 10% in hardware revenue, when compared to the same period in fiscal year 2009. Systems Gross Margin. Systems gross margin increased to 72% in fiscal year 2010 from 71%, in the same period in fiscal year 2009, primarily as a result of a change in the mix of products sold in the comparative periods and a reduction in hardware revenue year over year. Selling, General and Administrative Expenses. SG&A expenses decreased $9.5 million, or 4%, in fiscal year 2010, when compared to the same period in fiscal year 2009, due primarily to decreases in accounting, legal and consulting fees and partially offset by increases in advertising and promotional expenditures and bad debt expense during the same period. Advertising and promotional expenditures increased due primarily to Systems promotional events during the fiscal year. Bad debt expense increased due primarily to increase in accounts receivable and the write-off of certain notes receivable during the same period. Bad debt as a percentage of revenue was under 1%. Accounting fees and legal fees decreased due to a reduction in services provided during the same period as a result of improved internal controls and fewer litigation related expenses. The decrease in consulting expense was due to a company-wide initiative to reduce external consulting and convert individuals to full time positions only where necessary. SG&A expenses in fiscal year 2009 benefited from a $3.0 million insurance reimbursement from claims for the 2005 U.S. Gulf Coast hurricanes which destroyed or temporarily shut down our gaming operations in the region when our rental and daily fee games were destroyed in third party locations. Research and Development Costs. R&D costs increased $3.0 million, or 4%, in fiscal year 2010, when compared to the same period in the prior fiscal year, due primarily to an increase in employees and an increase in the development of our ALPHA 2 operating systems and system products. The increased costs were attributable to our continued focus on our technology assets due to the competitive landscape that required a continual investment in future generations of gaming products and systems. Impairment Charges. Impairment charges of $11.4 million were recorded during fiscal year 2010 due to the evolving circumstances in Alabama where the legality of charitable bingo gaming was under challenge by the state's governor and there were also several lawsuits pending before the State's Supreme Court which could have negatively affected charitable gaming in the state. See Note 4 to the consolidated financial statements, Impairment Charges. Depreciation and Amortization Expense. Depreciation and amortization expense increased $0.5 million, or 3%, in fiscal year 2010, when compared to same period in the prior fiscal year, primarily as a result of additions of property and equipment year over year. 40 -------------------------------------------------------------------------------- Other Income (Expense), Income Tax Expense and Net Loss (Income) Attributable to Noncontrolling Interests Other income (expense) and income tax expense from continuing operations and net loss (income) attributable to noncontrolling interests was as follows: Year Ended June 30, 2011 2010 2009 (in 000s) Other income (expense) Interest income $ 5.0 $ 3.3 $ 3.4 Interest expense (12.0 ) (12.6 ) (19.1 ) Loss on extinguishment of debt (4.1 ) - (0.8 ) Other, net 3.0 (4.0 ) (1.5 ) Total other expense (8.1 ) (13.3 ) (18.0 ) Income tax expense (45.2 ) (60.7 ) (64.8 ) Net income (loss) attributable to noncontrolling interests (0.5 ) 1.9 1.9 Fiscal Year 2011 vs. Fiscal Year 2010 Other Income (Expense). Other expense decreased $5.2 million, or 39%, in fiscal year 2011, when compared to the same period last year, due primarily to an increase in gains on foreign currency translations of $6.8 million as a result of the weakening of the U.S. dollar during the same period. Interest expense decreased $0.6 million in fiscal year 2011, when compared to the same period last year, while interest income increased $1.7 million during the same period. As a result of amending and restating the credit facility, we incurred a loss on extinguishment of debt of $4.1 million for the write-off of certain debt issue costs. The interest rate on the term loan was 3.82% at June 30, 2011. In December 2008, we entered into a floating-to-fixed interest rate swap to fix the interest rate at 1.89% until September 2012. Effective June 2011, we entered into a second floating-to-fixed interest rate swap to fix the interest rate at 2.09% until the term loan's maturity in May 2016. Income Tax Expense. Income tax expense decreased $15.5 million during fiscal year 2011, when compared to the same period last year, due primarily to a reduction in net income, certain changes in our uncertain tax positions primarily resulting from settlement of the Internal Revenue Service ("IRS") examination of our 2003 to 2005 income tax returns, the reinstatement of the R&D tax credit and deferred tax expense on the repatriation of earnings from our India subsidiary. See Note 14 to the consolidated financial statements, Income Taxes. The effective income tax rate for continuing operations for fiscal year 2011 and 2010 was 31.5% and 35.5%, respectively. Net loss (income) attributable to noncontrolling interests. Net income attributable to noncontrolling interests decreased $2.4 million in fiscal year 2011, when compared to the same period last year. In fiscal year 2010, net income attributable to noncontrolling interests was due to earnings from unconsolidated subsidiaries, including the Rainbow Casino. See Note 3 to the consolidated financial statements, Discontinued Operations. Fiscal Year 2010 vs. Fiscal Year 2009 Other Income (Expense). Other expense decreased $4.7 million, or 26%, in fiscal year 2010, when compared to the same period in the prior fiscal year, due primarily to a decrease in interest expense during the same period. Interest expense decreased $6.5 million due primarily to a reduction in the principal balance on the term loan over the year. The interest rate on the term loan was 4.14% at 41 -------------------------------------------------------------------------------- June 30, 2010. Other expense decreases were offset by increases in losses incurred on foreign currency translations as a result of the strengthening U.S. dollar. Income Tax Expense. The effective income tax rate for continuing operations for fiscal years 2010 and 2009 was 35.5% and 35.0%, respectively. The effective income tax rate for fiscal year 2010 only reflected a half year benefit from the R&D tax credit while the effective income tax rate for fiscal year 2009 reflected the retroactive reinstatement of the R&D tax credit of approximately $3.1 million. The IRS commenced examination of our United States federal income tax returns for 2003 through 2005 in the fourth quarter of 2006. In January 2009, the IRS completed its field examination of the open tax years and issued a Revenue Agent's Report and we paid $3.4 million in tax and $1.2 million in interest to the IRS to settle certain agreed adjustments. We subsequently appealed certain unagreed issues to the IRS Appeals Division. On June 30, 2010 we agreed to settle all remaining issues with the IRS and we received a refund of $1.7 million in tax and $0.6 million in interest in December 2010. Net income attributable to noncontrolling interests. Net income attributable to noncontrolling interests was consistent in both fiscal years 2010 and 2009. Discontinued Operations On April 5, 2010, we entered into a definitive purchase agreement to sell the Rainbow Casino. Under the terms of the agreement, we received approximately $80.0 million in an all-cash transaction. The sale closed on June 8, 2010. We recognized a gain on the sale of Rainbow of approximately $22.1 million (net of approximately $12.2 million in income taxes) in the fourth quarter of fiscal year 2010. Per the terms of the sale agreement, we incurred certain post-closing adjustments during fiscal year 2011 which reduced our gain on the sale by approximately $0.4 million (net of approximately $0.2 million income taxes). The results of operations for fiscal years 2011, 2010 and 2009 were classified as discontinued operations because we did not continue to receive significant cash flows from the Rainbow Casino after the sale. Rainbow's revenues, reported in discontinued operations for fiscal years 2010 and 2009 were $34.3 million and $39.6 million, respectively. We recorded income from discontinued operations, net of income taxes, for fiscal years 2010 and 2009 of $7.2 million and $8.1 million, respectively. See Note 3 to the consolidated financial statements, Discontinued Operations. Financial Condition and Liquidity Working Capital June 30, June 30, Increase (decrease) 2011 2010 Amount % (in 000s) Cash and cash equivalents $ 66,425 $ 145,089 $ (78,664 ) (54 )% Total long-term debt, including current maturities $ 515,403 $ 173,793 341,610 197 % Total current assets $ 473,677 $ 476,409 $ (2,732 ) (1 )% Total current liabilities 160,616 174,553 (13,937 ) (8 )% Net working capital $ 313,061 $ 301,856 $ 11,205 4 % As of June 30, 2011 and 2010, we had $66.4 million and $145.1 million, respectively, in consolidated cash and cash equivalents from continuing operations. Pursuant to various state gaming regulations, certain cash accounts are maintained to ensure availability of funds to pay wide-area progressive jackpot awards in installments, rather than in one lump-sum. At 42 -------------------------------------------------------------------------------- June 30, 2011 and 2010, these accounts had an aggregate value of approximately $8.4 million and $8.3 million, respectively, which are classified as restricted cash in our consolidated balance sheets. In addition, we purchase U.S. Treasury Strip Securities for the benefit of jackpot winners who elect to receive winnings in annual or weekly installment payments. These securities are included in restricted long-term investments in the accompanying consolidated balance sheets, and totaled $12.5 million and $13.1 million as of June 30, 2011 and 2010, respectively. On June 30, 2011, the amount of cash and investments held by foreign subsidiaries was $18.2 million. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. Our net working capital increased $11.2 million in the fiscal year months ended June 30, 2011, when compared to the same period last year, and was primarily affected by the $78.7 million decrease in cash and cash equivalents during the same period and by net working capital increases for the following components: º • º An increase of $27.9 million in current accounts and notes receivable due primarily to certain new systems contracts and international sales during the period; º • º An increase of $25.8 million in inventories due primarily to the purchase of raw materials which increased in part due to acquisition of raw materials related to the new Pro Series cabinets and the build-up of inventory in our European location in preparation for the roll-out of products in Italy; and º • º A decrease of $27.4 million in current maturities of long-term debt due primarily to the new amended and restated credit facility and a reduction in quarterly principal payments from $11.25 million to $3.75 million for the next twelve-month period. Current and long-term accounts and notes receivable increased $27.9 million and $16.5 million, respectively, during the fiscal year ended June 30, 2011, when compared to the same period last year. Long-term accounts and notes receivable increased due primarily to an increase in loans to finance gaming opportunities to a customer in Italy during the current period. In addition, our DSO's increased to 116 days from 99 days at June 30, 2010 due primarily to an increase in certain new systems contracts and international sales over the last twelve months coupled with a decrease in revenue during the same period. On May 12, 2011, we concluded a modified Dutch auction tender offer to purchase up to $400 million of our common stock, purchasing 9.9 million shares at $40.18 per share for $398.3 million. During fiscal year 2011 we purchased a total of 12.0 million shares of our common stock for approximately $477.2 million. On April 15, 2011, we entered into an amended and restated credit agreement, that provides for a $700 million senior secured credit facility comprised of a $300 million, five-year term loan and a $400 million, five-year revolving credit facility, including a $50 million sublimit for the issuance of standby letters of credit, a $10 million sublimit for swingline loans and a $150 million sublimit for multicurrency borrowings approved under the credit facility. The interest rate on the credit facility is subject to a leverage-based pricing grid. If the leverage ratio, as defined under the credit facility, is greater than 2.5, the interest rate will be LIBOR plus a margin of 2.00%; if the leverage ratio is between 2.0 and 2.5, the interest rate will be LIBOR plus a margin of 1.75%; if the leverage ratio is between 1.5 and 2.0, the interest rate will be LIBOR plus a margin of 1.50%; if the leverage ratio is between 1.0 and 1.5, the interest rate will be LIBOR plus a margin of 1.25%; and if the leverage ratio is below 1.0, the interest rate will be LIBOR plus a margin of 1.00%. As of June 30, 2011 and 2010, our leverage ratio was below 2.5 and 1.0, respectively. 43 -------------------------------------------------------------------------------- Effective December 2008, we entered into a floating-to-fixed interest rate swap agreement with an original notional value of $218.8 million and a maturity date of September 26, 2012 to fix floating LIBOR based debt to fixed rate debt at an interest rate of 1.89%. Effective June 2011, we entered into a second floating-to-fixed rate swap agreement with an original notional value of $165.0 million and a maturity date of May 13, 2016 to fix a portion of the floating LIBOR based debt under the new term loan to fixed rate debt at an interest rate of 2.09%. At June 30, 2011, the combined swap agreements had a notional value of$296.3 million. Under the credit facility, the term loan requires quarterly principal reductions in an amount equal to 1.25% of the effective date term loan amount, or $3,750,000, through March 2013; an amount equal to 1.875% of the effective date term loan amount, or $5,625,000, through March 2014; an amount equal to 2.50% of the effective date term loan amount, or $7,500,000, from June 2014 until the term loan's maturity in May 2016 upon when the remaining outstanding principal balance of $187,500,000 is due. The credit facility is collateralized by substantially all of our domestic property and is guaranteed by each of our domestic subsidiaries, excluding any noncontrolling interests, and is secured by a pledge agreement. The fair value of long-term debt is estimated by discounting expected cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings and remaining maturities. As of June 30, 2011 and 2010, the fair value of long-term debt approximated the carrying value. The credit facility contains a number of covenants that, among other things, restrict our ability and certain of our subsidiaries to dispose of assets, incur additional indebtedness or issue preferred stock, pay dividends or make other distributions, enter into certain acquisitions, repurchase equity interests or subordinated indebtedness, issue or sell equity interests of our subsidiaries, engage in mergers or acquisitions or certain transactions with subsidiaries and affiliates, and that otherwise restrict corporate activities. The financial covenants under the credit facility consist of a leverage ratio and an interest coverage ratio. The leverage ratio is computed as total debt outstanding at the end of the quarter divided by the trailing twelve months Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), excluding certain cash and non-cash charges. The interest coverage ratio is computed as EBITDA for the trailing twelve months divided by the trailing twelve months of interest charges. A breach of any of the covenants or the inability to comply with the required financial ratios could result in a default under the credit facility. In the event of any such default, the lenders could elect to declare all borrowings outstanding under the credit facility, together with any accrued interest and other fees, to be due and payable. If we were unable to repay the indebtedness upon its acceleration, the lenders could proceed against the underlying collateral. We were in compliance with all of the credit facility covenants as of June 30, 2011. As of June 30, 2011, there was approximately $181.0 million of undrawn availability under the revolving credit facility. Availability under the revolving credit facility is reduced to the extent of outstanding letters of credit. Management believes that cash flows from current operating activities will provide us with sufficient capital resources and liquidity to operate our business for at least the next 12 months. At June 30, 2011, we had no material commitments for capital expenditures. Cash Flow Summary Our primary sources of liquidity include existing cash and cash equivalents, cash flows from all operating activities and the availability of funds under our revolving credit facility. 44 -------------------------------------------------------------------------------- Cash flows from continuing operating activities are derived from Bally Gaming Equipment and Systems. Cash flows from discontinued operating activities, or Casino Operations, were derived from the operation of the Rainbow Casino. We utilize our cash to acquire materials for the manufacture of goods for resale, to pay payroll, interest, taxes and SG&A expenses and to fund R&D activities. Cash flows provided by continuing operating activities were $56.8 million in fiscal year 2011 as compared to $129.1 million in the same period last year, a $72.3 million decrease. Cash flows from operating activities of continuing operations for fiscal year 2011 were negatively impacted by our investment in inventories to significantly expand our installed base of leased gaming equipment and to build games for the new market opportunity in Italy, and to a lesser extent, a reduction in income from continuing operations. Cash flows used by discontinued operations were $0.4 million in fiscal year 2011, when compared to $9.5 million in fiscal year 2010. Cash utilized for investing activities from continuing operations is primarily for capital expenditures related to furniture, fixtures, office and gaming equipment and improvements in leaseholds, financing arrangements with customers and investments in technology and other long-term assets. During fiscal years 2011 and 2010, we provided $9.9 million and $15.8 million, respectively, in loans to finance gaming opportunities for certain customers, and made capital expenditures of $13.2 million and $11.6 million, respectively, during the same period. Cash provided by investing activities from discontinued operations was $78.8 million during fiscal year 2010 and was primarily for proceeds from the sale of Rainbow of approximately $80.0 million offset by additions to property, plant and equipment during the same period. Cash utilized for financing activities from continuing operations is primarily for the payment of principal on our debt and the purchase of shares of our common stock. During fiscal year 2011 we purchased 12.0 million shares of our common stock for approximately $477.2 million. With proceeds of $300 million from the term loan and $229 million in borrowings under our revolving credit facility, each after the amendment and restatement of the credit facility, we purchased $398.3 million worth of shares from the tender, paid off our prior credit facility of $142.5 million and paid debt issuance costs for the amendment and restatement of the credit facility of $7.1 million. During fiscal year 2011, we also made additional payments of $66.9 million on our notes payable and our revolving credit facility. During fiscal year 2010, we made payments of $35.3 million on our notes payable and purchased 2.3 million shares of our common stock for $91.2 million under our share repurchase plan. Cash provided by financing activities is primarily from proceeds from the exercise of stock options and purchases of stock under our Employee Stock Purchase Plan ("ESPP"), borrowings under our revolving credit facility, and excess tax benefits of stock option exercises. During fiscal year 2011, we also borrowed $21.9 million under our revolving credit facility, and employees exercised options for 1.6 million shares of common stock for $26.3 million and purchased 67,730 shares of common stock for $2.1 million under our ESPP. During fiscal year 2010, employees exercised options for 2.1 million shares of common stock for $30.1 million and purchased 53,716 shares of common stock for $1.9 million under our ESPP. 45 -------------------------------------------------------------------------------- Contractual Commitments We are committed to make future payments pursuant to various contracts and agreements. A summary of those contractual obligations existing as of June 30, 2011, grouped according to the periods in which such payments are due, is as follows: Payments Due By Period Less than More than 1 year 1-3 years 3-5 years 5 years Total (in 000s) Debt: Revolving credit facility $ - $ - $ 219,000 $ - $ 219,000 Term loan facility(1) 15,000 41,250 240,000 - 296,250 Other, generally unsecured debt 153 - - - 153 $ 15,153 $ 41,250 $ 459,000 $ - $ 515,403 Estimated interest payments(2) 15,965 30,475 25,319 - 71,759 $ 31,118 $ 71,725 $ 484,319 $ - $ 587,162 Other commitments: Operating leases(3) 8,584 10,891 4,831 1,490 25,796 Purchase commitments(4) - - - - - Jackpot liabilities(5) 11,894 601 645 4,581 17,721 Employment agreements(6) 998 1,497 - - 2,495 Total commitments $ 52,594 $ 84,714 $ 489,795 $ 6,071 $ 633,174 -------------------------------------------------------------------------------- º (1) º Our term loan requires quarterly principal reductions in an amount equal to 1.25% of the effective date term loan amount, or $3,750,000, through March 2013; an amount equal to 1.875% of the effective date term loan amount, or $5,625,000, through March 2014; an amount equal to 2.50% of the effective date term loan amount, or $7,500,000, from June 2014 until the term loan's maturity date in May 2016 upon when the remaining outstanding principal balance of $187,500,000 is due. º (2) º Loans under the credit facility bear interest at a variable rate equal to either the applicable base rate or LIBOR, plus in each case an interest margin determined by our leverage ratio. If the leverage ratio, as defined under the credit facility, is greater than 2.5, the interest rate will be LIBOR plus a margin of 2.00%; if the leverage ratio is between 2.0 and 2.5, the interest rate will be LIBOR plus a margin of 1.75%; if the leverage ratio is between 1.5 and 2.0, the interest rate will be LIBOR plus a margin of 1.50%; if the leverage ratio is between 1.0 and 1.5, the interest rate will be LIBOR plus a margin of 1.25%; and if the leverage ratio is below 1.0, the interest rate will be LIBOR plus a margin of 1.00%. As of June 30, 2011, our leverage ratio was below 2.5. Effective December 2008, we entered into a floating-to-fixed interest rate swap agreement with an original notional value of $218.8 million and a maturity date of September 26, 2012 to fix floating LIBOR based debt to fixed rate debt at an interest rate of 1.89%. Effective June 2011, we entered into a second floating-to-fixed rate swap agreement with an original notional value of $165.0 million and a maturity date of May 13, 2016 to fix a portion of the floating LIBOR based debt under the new term loan to fixed rate debt at an interest rate of 2.09%. At June 30, 2011, the combined swap agreements had a notional value of $296.3 million. We computed estimated future interest payments for our term loan and revolving credit facilities using interest rates as of June 30, 2011 of approximately 3.82% and 2.29%, respectively. The term loan facility interest rate includes both floating-to-fixed rate swap agreements for their respective remaining terms assuming our leverage ratio will continue to be below 2.5. 46 -------------------------------------------------------------------------------- º (3) º Consists of operating leases for our facilities, autos and office equipment, less sublease income, that expire at various times through fiscal year 2019. º (4) º Consisted of a commitment to purchase components related to the production of gaming devices which was fulfilled in April 2011 of which approximately $17.2 million and $468,000 of components were purchased in fiscal years 2011 and 2010, respectively. º (5) º Represents amounts payable to future jackpot winners on our wide-area progressive systems. º (6) º We have employment agreements with most of our employees with positions of Vice President or above. These agreements generally provide for an initial rate of pay and other general employment terms. Some include post-employment non-compete provisions and the terms of the severance benefits generally range from three to twelve months salary continuation with similar non-compete periods. Almost all such agreements contain language that the employee is still an "at will" employee, and as such can be terminated at anytime subject to the individual termination provisions. The only multi-year employment arrangement is with Richard Haddrill, our CEO. As of June 30, 2011, we had a liability for unrecognized tax benefits of $9.3 million, including accrued interest and penalties. It is difficult to estimate the period of cash settlement for the liability for unrecognized tax benefits; however we believe it is reasonably possible that the amount of unrecognized tax benefits may decrease in fiscal year 2012 by up to $0.3 million. See Note 14 to the consolidated financial statements, Income Taxes, for a further discussion on our income tax positions. Off Balance Sheet Arrangements We are party to financial instruments with off-balance sheet risk, such as performance bonds and other guarantees not reflected in our balance sheet that arise in the normal course of business. However, such off balance sheet arrangements are not reasonably likely to have a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or resources. Critical Accounting Policies We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Our accounting policies are more fully described in Note 1 to the consolidated financial statements, Description of Business and Summary of Significant Accounting Principles. Some of our accounting policies require us to make difficult, complex and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We considered the following critical accounting policies to be the most important to understanding and evaluating our financial results and require the most subjective and complex judgments made by management. We have discussed the development, selection and disclosure of our critical accounting policies and estimates with the Audit Committee of our Board of Directors. There can be no assurance that actual results will not differ from our estimates. Revenue recognition Our revenue recognition policy is to record revenue when all of the following criteria have been satisfied: º • º Persuasive evidence of an arrangement exists; º • º The price or fee to the customer is fixed or determinable; º • º Collectability is reasonably assured; º • º Delivery has occurred; and º • º No significant contractual obligations remain. 47 -------------------------------------------------------------------------------- Revenues are reported net of incentive rebates, discounts, sales taxes, and other taxes of a similar nature. For products sold under arrangements with extended payment terms the probability of collection is evaluated based on a review of the customer's credit worthiness and a review of historic collection experience on contracts with extended payment terms. As a result of such review, we recognize revenue on extended payment term arrangements when we have determined that collectability is reasonably assured and the fees are fixed and determinable. Games placed with customers on a trial basis are not recognized as revenue until the trial period ends, the customer accepts the games and all other relevant criteria have been met. Amounts billed to customers prior to completing the earnings process are deferred until the revenue recognition criteria are met. Effective July 1, 2009, we adopted new accounting guidance related to revenue recognition for multiple deliverable arrangements and certain revenue arrangements that include software elements. We elected to adopt this guidance prior to the required effective date using the prospective method. Accordingly, this guidance was applied to all new or materially modified revenue arrangements entered into since the start of our fiscal year of adoption, which was July 1, 2009. Prior to the adoption of the new revenue recognition guidance gaming equipment and systems revenue was recognized in accordance with software revenue recognition guidance. The new guidance amended the scope of software revenue recognition to exclude all tangible products containing both software and nonsoftware components that function together to deliver the product's essential functionality. As a result of applying the new guidance, certain products that were previously accounted for under the scope of software revenue recognition guidance are no longer accounted for as software. Considerable judgment is necessary to determine whether certain of our products are within the scope of software revenue recognition and whether the software and nonsoftware elements of these products function together to deliver the essential functionality. This determination dictates whether general revenue recognition guidance or software revenue recognition guidance applies and could impact the timing of revenue recognition. Considerable judgment is also required to determine whether an arrangement consists of multiple deliverables, whether the delivered item has value to the customer on a stand-alone basis and determining the relative selling price used to allocate the arrangement fee to each deliverable. Such determination affects the amount and timing of revenue recognition. Management evaluates the primary use and functionality of each deliverable in determining whether a delivered item has stand-alone value and qualifies as a separate unit of accounting. Judgments for revenue recognition also involve an assessment as to whether collectability is reasonably assured and whether fees under an arrangement are fixed or determinable. Gaming Operations Revenue. Gaming operations revenue consists of the operation of linked progressive systems and the rental of gaming devices, game content and the related systems placed with customers. Fees under these arrangements are earned and recognized based on a share of money wagered, a share of the net winnings, or on a fixed daily rate. The daily fee entitles the customer to full use of the gaming device and includes maintenance, licensing of the game content software and connection to a linked progressive system, where applicable. In certain markets, we also charge a daily system connection fee for the customer to connect to a central determination system and/or back-office system. We do not consider these arrangements to have multiple revenue-generating activities as the services offered are a comprehensive solution in exchange for a daily fee and all of the products and services are delivered contemporaneously. Gaming operations revenue is recognized under general revenue recognition guidance as the deliverables provide the customer with rights to use tangible gaming devices and software that is essential to the functionality of the gaming device. 48 -------------------------------------------------------------------------------- Gaming Equipment Revenue. Gaming Equipment revenue is generated from the sale of gaming devices and licensing rights to game content software that is installed in the gaming device, parts, and other ancillary equipment. Arrangements may also include sales of game content conversion kits which enable customers to replace game content without purchasing a new gaming device. Gaming equipment arrangements do not include maintenance and product support fees beyond a standard warranty period. The recognition of revenue from the sale of gaming devices occurs as title and risk of loss have passed to the customer and all other criteria have been satisfied. As the combination of game content software and the tangible gaming device function together to deliver the product's essential functionality, revenue from the sale of gaming devices is recognized under general revenue recognition guidance. Prior to July 1, 2009, gaming devices were recognized under software revenue recognition guidance. Game content conversion kits are considered software deliverables and are recognized in accordance with software revenue recognition guidance. Systems Revenue. Systems revenue arrangements generally include a combination of systems software licenses, systems-based hardware products, maintenance and product support fees and professional services. The primary function of systems software licensed by us is to aid customers to more effectively run their business with marketing, data management and analysis, accounting, player tracking and security features. Revenue for systems software and maintenance and product support fees is recognized under software revenue recognition guidance. Although the systems software and certain systems-based hardware function together, the primary functionality of the systems software is derived from the software and the systems software is not essential to the functionality of the systems-based hardware. We license systems software on a perpetual basis or under time-based licenses. Revenue from perpetual license software is recognized at the inception of the license term if all revenue recognition criteria have been met. Revenue from maintenance and product support fees sold with perpetual licenses is recognized over the term of the support period. Our time-based licenses are generally for twelve month terms and are bundled with software maintenance and product support fees. All revenue from such arrangements is recognized over the term of the license. Systems-based hardware includes embedded software that is essential to the functionality of the hardware. Accordingly, revenue related to all systems-based hardware sales and related maintenance and product support fees are recognized under general revenue recognition guidance. Prior to July 1, 2009, systems-based hardware was recognized under software revenue recognition guidance. Revenue from the sale of systems-based hardware is generally recognized upon delivery when title and risk of loss have passed to the customer and all other revenue recognition criteria are met. However, in the case of arrangements involving a systems installation, revenue on systems-based hardware is generally not recognized until the system has been installed and the customer has accepted the system. Hardware maintenance and product support fees are recognized during the term of the support period which is generally 12 months. Software maintenance and product support provides customers with rights to unspecified software product upgrades, maintenance and patches released during the term of the support period. Our software maintenance and product support arrangements are generally for 12 month periods. Software maintenance and product support is recognized on a straight-line basis over the term of the support period. Multiple Element Arrangements. We enter into revenue arrangements that may consist of multiple deliverables of our products and services. Customers may enter into arrangements with us for the implementation of systems software and the sale of gaming devices. Arrangements for the implementation of systems software will generally include a combination of systems software licenses, systems-based hardware products, maintenance and product support fees, and professional services. 49 -------------------------------------------------------------------------------- Certain gaming equipment arrangements may also include the sale of gaming devices and game conversion kits. Revenue arrangements with multiple deliverables are allocated to separate units of accounting if the deliverables meet both of the following criteria: º • º The delivered items have value to the customer on a standalone basis. The items have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered items on a standalone basis; and º • º If the arrangement includes a general right of return relative to the delivered items, delivery or performance of the undelivered items is considered probable and substantially in the control of us. At the inception of a multiple element arrangement, fees under the arrangement are allocated to the nonsoftware deliverables, and to the software deliverables as a group based on their relative selling price. Software deliverables are further subject to separation and allocation based on software revenue recognition guidance as described in the following paragraph. When applying the relative selling price method, a hierarchy is used for estimating the selling price based first on vendor-specific objective evidence ("VSOE"), then third-party evidence ("TPE") and finally management's estimate of the selling price ("ESP"). Revenue for each unit of accounting is recognized when the relevant recognition criteria for each respective element has been met. In allocating arrangement fees under the relative selling price hierarchy, we use VSOE for all products which have been sold on a stand-alone basis. As TPE is generally not available, we use ESP for products that are not sold on a stand-alone basis and for recently introduced products that are sold on a stand-alone basis but for which a history of stand-alone sales has not yet been developed. Following these guidelines, we use either VSOE or ESP for gaming devices, system-based hardware products, maintenance and product support fees associated with perpetual licenses and professional services; and ESP for perpetual and time-based software licenses and maintenance and product support fees associated with time-based licenses. We use the residual method to recognize revenue allocated to software deliverables. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element and is recognized as revenue. In arrangements in which we do not have VSOE of fair value of all undelivered software elements, revenue is deferred until delivery occurs or VSOE of fair value has been established for any remaining undelivered software elements. In the event the only undelivered software element is maintenance and product support for which VSOE of fair value does not exist, the revenue is recognized ratably over the maintenance and product support period. The establishment of VSOE requires judgment as to whether there is a sufficient quantity of items sold on a stand-alone basis and whether the prices demonstrate an appropriate level of concentration to conclude that VSOE exists. In determining ESP, management considers a variety of information including historic pricing and discounting practices, competitive market activity, internal costs, and the pricing and discounting practices of products sold in bundled arrangements. Inventories Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market value. Cost elements included in work-in-process and finished goods include raw materials, direct labor and manufacturing overhead. We regularly review inventory quantities and update estimates for the net realizable value of inventories due to the subjectivity involved in projecting sales volumes, used game sales values, refurbishment costs, and product demand. This process includes examining the carrying values of new and used gaming devices, parts and ancillary equipment in comparison to the current fair 50 -------------------------------------------------------------------------------- market values for such equipment (less costs to sell or dispose). Some of the factors involved in this analysis include the overall levels of our inventories, the current and projected sales levels for such products, the projected markets for such products, the costs required to sell the products, including refurbishment costs and importation costs for international shipments, and the overall projected demand for products once the next generation of products are scheduled for release. As a result of our ongoing analysis of inventory, we recognized inventory write-downs totaling $3.6 million, $2.0 and $4.5 million during the years ended June 30, 2011, 2010 and 2009, respectively. Additional valuation charges could occur in the future as a result of changes in the factors listed above. Leased gaming equipment Leased gaming equipment is stated at cost and depreciated over estimated useful lives ranging from two to three and one-half years. The estimation of useful lives for our leased gaming equipment requires judgment and is based on the period of time over which we believe the assets will be of economic benefit. Given changes in technology, customer preferences and product demand, we review and evaluate the recoverability of our investment in such assets on a quarterly basis, as well as the estimated useful lives used to depreciate these assets. There is the potential for acceleration of future depreciation, or asset impairments, if conditions were to change and certain factors were determined to have an adverse impact on our ability to realize our full investment in such assets. Impairment of long-lived assets and goodwill We review long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of long-lived assets are measured by a comparison of the carrying amount of the asset to future, net cash flows expected to be generated by the asset, undiscounted and without interest. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. We review goodwill for impairment annually at the beginning of our fourth fiscal quarter, or whenever events or circumstances indicate the carrying value may not be recoverable or warrant a revision to the estimated remaining useful life. We perform the impairment analysis of goodwill at a reporting unit level by comparing the fair value of a reporting unit with its carrying value, including goodwill. If the fair value is less than the carrying value, the impairment to be recognized is measured by the amount by which the carrying amount of the goodwill exceeds the fair value of the reporting unit goodwill. We are required to make significant judgments and estimates regarding future cash flows, the determination of fair values and the identification of reporting units utilized in determining the fair value and recoverability of long-lived assets and goodwill. We believe our estimates are reasonable; however, if our estimates materially differ or factors utilized in developing our estimates change, different assumptions could materially affect our assessment of the fair value and recoverability of long-lived assets and goodwill. During the year ended June 30, 2010, impairment charges of $5.9 million related to long-lived assets were recorded (see Note 4 to the consolidated financial statements, Impairment Charges). During the years ended June 30, 2011 and 2009, no impairment charges related to long-lived assets were recorded. During the years ended June 30, 2011, 2010 and 2009, no impairment charges related to goodwill were recorded. 51 -------------------------------------------------------------------------------- Share-based compensation We account for share-based compensation based on the calculated fair value of the award measured on the grant date which is recognized, net of estimated forfeitures, as expense over the employee's requisite service period which is generally the vesting period of the equity grant. Determining the appropriate fair value model and calculating the fair value of share-based awards requires the input of highly subjective assumptions including the expected option term and the expected volatility of our common stock over the option's expected term. We believe that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of stock options granted; however, if actual results differ significantly from these estimates, share-based compensation expense could be materially impacted. In addition, we are required to estimate the expected forfeiture rate, and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the share-based compensation expense could be significantly different from what we have recorded. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. Pre-tax share-based compensation expense from continuing operations was $12.9 million, $13.8 million and $16.3 million during the years ended June 30, 2011, 2010 and 2009, respectively. As of June 30, 2011, there was $11.2 million of total unrecognized compensation expense related to the unvested portion of stock options which will be recognized over the subsequent 1.89 years. In addition, as of June 30, 2011, there was $12.0 million of total unrecognized compensation expense related to the unvested portion of restricted stock and Restricted Stock Units ("RSUs") which will be recognized over the subsequent 1.76 years. Income taxes We conduct business globally and are subject to income taxes in U.S. federal, state, local, and foreign jurisdictions. Determination of the appropriate amount and classification of income taxes depends on several factors, including estimates of the timing and probability of realization of deferred income taxes, reserves for uncertain income tax positions and income tax payment timing. We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. Taxes on income of our foreign subsidiaries are provided at the tax rates applicable to the tax jurisdictions in which they are located. The recoverability of certain deferred tax assets is based in part on estimates of future income and the timing of temporary differences, and the failure to fully realize such deferred tax assets could result in a higher tax provision in future periods. Our net deferred tax assets from continuing operations totaled $40.6 million and $65.0 million at June 30, 2011 and 2010, respectively. Our accrued income taxes payable totaled $3.0 million and $7.0 million and our accrued income taxes receivable totaled $47.3 million and $16.5 million at June 30, 2011 and 2010, respectively. We have classified $11.0 million of the accrued income taxes receivable at June 30, 2011 as long term as we do not expect collection of these amounts in the next twelve months. We apply FASB Topic 740 "Accounting for Uncertainty in Income Taxes" to our uncertain tax positions. Under the guidance, we may recognize a tax benefit from an uncertain position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the 52 -------------------------------------------------------------------------------- technical merits of the issue. The amount recognized in the financial statements is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. We are required to make significant judgments when evaluating our uncertain tax positions and the related tax benefits. We believe our assumptions are reasonable; however, there is no guarantee that the final outcome of the related matters will not differ from the amounts reflected in our income tax provisions and accruals. We adjust our liability for uncertain tax positions based on changes in facts and circumstances such as the closing of a tax audit or changes in estimates. Our income tax provision may be impacted to the extent that the final outcome of these tax positions is different than the amounts recorded. As of June 30, 2011 and 2010, our liabilities for unrecognized tax benefits totaled $8.4 million and $11.6 million, respectively. Of this amount, $8.2 million and $10.2 million as of June 30, 2011 and 2010, respectively, if recognized, would impact the effective tax rate. Recently adopted accounting pronouncements For a description of recently adopted accounting pronouncements, see Note 1 to the consolidated financial statements, Summary of Significant Accounting Policies. Recently issued accounting pronouncements not yet adopted For a description of recently issued accounting pronouncements not yet adopted, see Note 1 to the consolidated financial statements, Summary of Significant Accounting Policies. [ Back To TMCnet.com's Homepage ]