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EX-32 - EXHIBIT 32 - AP Gaming Holdco, Inc.ex32-201793010q.htm
EX-31.2 - EXHIBIT 31.2 - AP Gaming Holdco, Inc.ex312-201793010q.htm
EX-31.1 - EXHIBIT 31.1 - AP Gaming Holdco, Inc.ex311-201793010q.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
 
 
FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
for the quarter ended September 30, 2017
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
for the transition period from                          to                          .
Commission file number 000-55119
 
 
 
 
 
AP GAMING HOLDCO, INC.
(Exact name of registrant as specified in its charter)
Delaware
 
46-3698600
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
5475 S. Decatur Blvd., Ste #100 Las Vegas, NV 89118
(Address of principal executive offices) (Zip Code)
(702) 722-6700 
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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  x  No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  o  No  x*
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  o
 
Accelerated filer o
 
Non-accelerated filer  x (Do not check if a smaller reporting company)
 
Smaller reporting company  o
 
Emerging growth company  x 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o  No  x
As of November 10, 2017, there were 100 shares of the Registrant’s Class A common stock, $.01 par value per share, and 15,041,361 shares of the Registrant’s Class B common stock, $.01 par value per share, outstanding.
*The Company does not have any public stockholders. Accordingly, it does not maintain an investor relations website where Interactive Data Files would be posted.



TABLE OF CONTENTS

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

ii


PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AP GAMING HOLDCO, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share and per share data)
(unaudited)
 
September 30,
2017
 
December 31,
2016
Assets
Current assets
 
 
 
Cash and cash equivalents
$
10,025

 
$
17,977

Restricted cash
100

 
100

Accounts receivable, net of allowance of $1,638 and $1,972, respectively
34,484

 
24,035

Inventories
18,885

 
10,729

Prepaid expenses
3,734

 
2,609

Deposits and other
3,392

 
3,052

Total current assets
70,620

 
58,502

Property and equipment, net
75,461

 
67,926

Goodwill
257,845

 
251,024

Deferred tax asset
9

 
9

Intangible assets
211,768

 
232,877

Other assets
24,058

 
23,754

Total assets
$
639,761

 
$
634,092

 
 
 
 
Liabilities and Stockholders’ Equity
Current liabilities
 
 
 
Accounts payable
$
10,353

 
$
8,790

Accrued liabilities
23,005

 
17,702

Current maturities of long-term debt
6,674

 
6,537

Total current liabilities
40,032

 
33,029

Long-term debt
573,068

 
547,238

Deferred tax liability - noncurrent
9,111

 
6,957

Other long-term liabilities
37,001

 
30,440

Total liabilities
659,212

 
617,664

Commitments and contingencies (Note 13)

 

Stockholders’ equity

 
 
Preferred stock at $0.01 par value; 100,000 shares authorized, no shares issued and outstanding

 

Common stock at $0.01 par value; 30,000,100 shares authorized; 100 Class A Shares issued and outstanding at September 30, 2017 and December 31, 2016, and 14,931,529 Class B Shares issued and outstanding at September 30, 2017 and December 31, 2016.
149

 
149

Additional paid-in capital
177,276

 
177,276

Accumulated deficit
(193,037
)
 
(156,451
)
Accumulated other comprehensive loss
(3,839
)
 
(4,546
)
Total stockholders’ (deficit) equity
(19,451
)
 
16,428

Total liabilities and stockholders’ equity
$
639,761

 
$
634,092

The accompanying notes are an integral part of these condensed consolidated financial statements.

1


AP GAMING HOLDCO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(amounts in thousands, except per share data)
 (unaudited)
 
Three months ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues
 
 
 
 
 
 
 
Gaming operations
$
42,849

 
$
38,877

 
$
125,040

 
$
117,093

Equipment sales
13,591

 
2,331

 
29,254

 
6,968

Total revenues
56,440

 
41,208

 
154,294

 
124,061

Operating expenses
 
 
 
 
 
 
 
Cost of gaming operations1
7,344

 
6,711

 
21,794

 
19,627

Cost of equipment sales1
6,330

 
698

 
14,326

 
4,244

Selling, general and administrative
9,742

 
12,970

 
30,368

 
36,654

Research and development
6,467

 
6,675

 
17,912

 
16,517

Write downs and other charges
490

 
1,852

 
2,655

 
2,153

Depreciation and amortization
16,931

 
19,419

 
53,598

 
60,527

Total operating expenses
47,304

 
48,325

 
140,653

 
139,722

Income (loss) from operations
9,136

 
(7,117
)
 
13,641

 
(15,661
)
Other (income) expense
 
 
 
 
 
 
 
Interest expense
12,666

 
14,903

 
42,380

 
44,151

Interest income
(25
)
 
(12
)
 
(80
)
 
(51
)
Loss on extinguishment and modification of debt


 

 
8,129

 

Other (income) expense
(467
)
 
392

 
(4,805
)
 
6,314

Loss before income taxes
(3,038
)
 
(22,400
)
 
(31,983
)
 
(66,075
)
Income tax (expense) benefit
(1,052
)
 
1,165

 
(4,603
)
 
4,935

Net loss
(4,090
)
 
(21,235
)
 
(36,586
)
 
(61,140
)
Foreign currency translation adjustment
(498
)
 
(208
)
 
707

 
(2,137
)
Total comprehensive loss
$
(4,588
)
 
$
(21,443
)
 
$
(35,879
)
 
$
(63,277
)
 
 
 
 
 
 
 
 
Basic and diluted loss per common share:
 
 
 
 


 
 
Basic
$
(0.27
)
 
$
(1.42
)
 
$
(2.45
)
 
$
(4.09
)
Diluted
$
(0.27
)
 
$
(1.42
)
 
$
(2.45
)
 
$
(4.09
)
Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
14,932

 
14,932

 
14,932

 
14,932

Diluted
14,932

 
14,932

 
14,932

 
14,932

(1) exclusive of depreciation and amortization

The accompanying notes are an integral part of these condensed consolidated financial statements.


2


AP GAMING HOLDCO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Nine months ended September 30,
 
2017
 
2016
Cash flows from operating activities
 
 
 
Net loss
$
(36,586
)
 
$
(61,140
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
53,598

 
60,527

Accretion of contract rights under development agreements and placement fees
3,459

 
3,538

Amortization of deferred loan costs and discount
2,315

 
2,617

Payment-in-kind interest payments
(2,698
)
 

Write off of deferred loan cost and discount
3,294

 

Payment-in-kind interest capitalized
7,807

 
7,490

Provision for bad debts
902

 
1,274

Loss on disposition of assets
2,896

 
558

Impairment of assets
333

 
4,606

Provision (benefit) for deferred income tax
2,147

 
(6,374
)
Changes in assets and liabilities that relate to operations:
 
 
 
Accounts receivable
(9,649
)
 
(556
)
Inventories
(453
)
 
1,121

Prepaid expenses
(1,119
)
 
1,673

Deposits and other
(276
)
 
165

Other assets, non-current
(2,010
)
 
673

Accounts payable and accrued liabilities
2,333

 
9,089

Net cash provided by operating activities
26,293

 
25,261

Cash flows from investing activities
 
 
 
Business acquisitions, net of cash acquired

(7,000
)
 

Purchase of intangible assets
(565
)
 
(1,311
)
Software development and other expenditures
(6,334
)
 
(4,929
)
Proceeds from disposition of assets
171

 
87

Purchases of property and equipment
(35,961
)
 
(21,817
)
Net cash used in investing activities
(49,689
)
 
(27,970
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of first lien credit facilities
448,725

 

Repayment of senior secured credit facilities
(410,655
)
 
(3,175
)
Payments on first lien credit facilities

(1,125
)
 

Deferred offering costs paid
(1,203
)
 

Payment of financed placement fee obligations
(2,971
)
 
(3,525
)
Payments on deferred loan costs
(3,127
)
 

Repayment of seller notes
(12,401
)
 

Payments on equipment long term note payable and capital leases
(1,832
)
 
(1,993
)
Payment of previous acquisition obligation

 
(1,125
)
Proceeds from employees in advance of common stock issuance
25

 

Net cash used in financing activities
15,436

 
(9,818
)
Effect of exchange rates on cash and cash equivalents
8

 
(45
)
Decrease in cash and cash equivalents
(7,952
)
 
(12,572
)
Cash and cash equivalents, beginning of period
17,977

 
35,722

Cash and cash equivalents, end of period
$
10,025

 
$
23,150

 
 
 
 
Supplemental cash flow information:
 
 
 
Cash paid during the period for interest
$
26,744

 
$
29,340

Cash paid during the period for taxes
$
847

 
$
922

Non-cash investing and financing activities:
 
 
 
Financed purchase of property and equipment
$
642

 
$
1,588

Financed purchase of intangible asset
$
4,866

 
$


The accompanying notes are an integral part of these condensed consolidated financial statements.

3

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)


NOTE 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

AP Gaming Holdco, Inc. (the “Company,” “AP Gaming,” “we,” “us,” or “our”) is a leading designer and supplier of gaming products and services for the gaming industry. The Company is a leader in the Class II Native American and Mexican gaming jurisdictions and has expanded its product lines to include Class III Native American, commercial and charity jurisdictions. We supply electronic gaming machines (“EGMs”), server-based systems and back-office systems that are used by casinos and various gaming locations. Since mid-2014, the Company has significantly broadened and diversified its product portfolio through both organic development and strategic acquisitions. We launched a new table products division in mid-2014 to provide live felt table games to casino operators. Through the acquisition of Amaya Americas Corporation (“Cadillac Jack”) on May 29, 2015, we greatly expanded our games library and EGM offerings. The Company also acquired online developer Gamingo Limited (formerly known as “RocketPlay”, currently known as “AGSi”) in June 2015, further expanding its offerings to include interactive products such as social casino games, available to play on mobile devices.

The Company operates and reports in the following three segments:

A. Electronic Gaming Machines

Our EGM segment offers a selection of video slot titles developed for the global marketplace, as well as EGM cabinets such as ICON, Halo, Colossal Diamonds (“Big Red”), and Orion. In addition to providing complete EGM units, we offer conversion kits that allow existing game titles to be converted to other game titles offered within that operating platform.

B. Table Products

Our table products include live proprietary table games and side bets, as well as ancillary table products. Products include both internally developed and acquired proprietary table games, side bets, and table technology related to blackjack, poker, baccarat, craps and roulette. We have acquired a number of popular brands, including In-Bet, Buster Blackjack, Double Draw Poker and Criss Cross Poker that are based on traditional well-known public domain games such as blackjack and poker; however, these proprietary games provide intriguing betting options that offer more excitement and greater volatility to the player, ultimately enhancing our casino customers’ profitability. Our Tornado product is unique in that it allows players to control the spin of the roulette ball by pressing a remote ball activation device. We believe this mechanism enhances player interaction without altering traditional roulette rules and procedures; similarly, our Double Ball Roulette game creates a unique game experience by allowing players to use two balls instead of one.

C. Interactive

Our social gaming products are primarily delivered through our mobile apps, Lucky Play Casino and Vegas Fever. The apps contain several game titles available for consumers to play for fun and with coins that they purchase through the app. Some of our most popular social games include content that is also popular in land-based settings such as Colossal Diamonds, So Hot, and Monkey in the Bank.

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain disclosures required by generally accepted accounting principles (“GAAP”) are omitted or condensed in these condensed consolidated financial statements. In the opinion of management, all adjustments (consisting of only normal recurring adjustments) that are necessary for a fair statement of the Company's financial position, results of operations and cash flows for the interim periods have been made. The interim results reflected in these condensed consolidated financial statements are not necessarily indicative of results to be expected for the full fiscal year. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2016.


4

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Principles of Consolidation

The accompanying condensed consolidated financial statements include the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires the Company to make decisions based upon estimates, assumptions, and factors considered relevant to the circumstances. Such decisions include the selection of applicable accounting principles and the use of judgment in their application, the results of which impact reported amounts and disclosures. Changes in future economic conditions or other business circumstances may affect the outcomes of the estimates and assumptions. Accordingly, actual results could differ materially from those anticipated.

Revenue Recognition

Gaming Operations

Gaming operations revenue is earned by providing customers with gaming machines, gaming machine content licenses, back-office equipment and linked progressive systems, which are collectively referred to as gaming equipment, under participation arrangements. The participation arrangements convey the right to use the equipment (i.e. gaming machines and related integral software) for a stated period of time, which typically ranges from one to three years and then the contract continues on a month-to-month basis thereafter. In some instances, the Company will enter arrangements for longer periods of time; however, the arrangements include the ability of the customer to cancel the contract and return the games to the Company, a provision which renders their contracts effectively month-to-month contracts. Primarily due to these factors, our participation arrangements are accounted for as operating leases. In some instances, we will offer a free trial period during which no revenue is recognized. If during or at the conclusion of the trial period the customer chooses to enter into a lease for the gaming equipment, we commence revenue recognition according to the terms of the agreement.

Under participation arrangements, the Company retains ownership of the gaming equipment installed at the customer facilities and receives either revenue based on a percentage of the win per day generated by the gaming equipment or a daily fee. Thus, in our condensed consolidated financial statements the Company records revenue monthly related to these arrangements and the gaming equipment is recorded in property and equipment, net on our balance sheet and depreciated over the expected life of the gaming equipment.

The majority of the Company’s leases require the Company to provide maintenance throughout the entire term of the lease. In some cases, a performance guarantee exists that, if not met, provides the customer with the right to return the gaming machines to the Company. This performance guarantee is considered a cancellation clause, a provision which renders their contracts effectively month-to-month contracts. Accordingly, the Company accounts for these contracts in a similar manner with its other operating leases as described above. Whether contractually required or not, the Company develops and provides new gaming titles throughout the life of the lease. Certain arrangements require a portion of the win per day to be retained by the customer to fund facility-specific marketing, advertising and promotions. These amounts retained by the customer reduce the monthly revenue recognized on each arrangement.

Gaming operations revenue is also earned from the licensing of table product content and is earned and recognized on a fixed monthly rate. Our social gaming products earn revenue from the sale of virtual coins or chips, which is recorded when the purchased coins or chips are used by the customer.


Equipment Sales

Revenues from the stand-alone product sales or separate accounting units are recorded when:

Pervasive evidence of an arrangement exists;
The sales price is fixed or determinable;
Delivery has occurred and services have been rendered; and
Collectability is reasonably assured.

5

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


Equipment sales are generated from the sale of gaming machines and licensing rights to game content software that is installed in the gaming machine, parts, and other ancillary equipment. Also included within the deliverables are delivery, installation and training, all of which occur within a few days of arriving at the customer location. Gaming equipment sales do not include maintenance 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 revenue recognition 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.

The Company enters into revenue arrangements that may consist of multiple deliverables of its products.
For example, gaming equipment arrangements may include the sale of gaming machines and game content conversion kits.

Revenue associated with arrangements with multiple deliverables is allocated to separate units of accounting if (1) the deliverables have value to the customer on a stand-alone basis or (2) 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 the Company.

At the inception of a multiple element arrangement, fees under the arrangement are allocated to deliverables based on their relative selling price. 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.

Cash and Cash Equivalents

Cash and cash equivalents consist primarily of deposits held at major banks and other marketable securities with original maturities of 90 days or less.

Restricted Cash

Restricted cash amounts represent funds held in escrow as collateral for the Company’s surety bonds for various gaming authorities and funds held to ensure the availability of funds to pay wide-area progressive jackpot awards.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts related to accounts receivable deemed to have a high risk of collectability. The Company reviews the accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. The Company analyzes historical collection trends and changes in the customers’ payment patterns, customer concentration, and credit worthiness when evaluating the adequacy of the allowance for doubtful accounts. A large percentage of receivables are with Native American tribes, and the Company has concentrations of credit risk with several tribes. The Company includes any receivable balances that are determined to be uncollectible in the overall allowance for doubtful accounts. Changes in the assumptions or estimates reflecting the collectability of certain accounts could materially affect the allowance for accounts receivable.

Inventories

Inventories consist primarily of parts and supplies that are used to repair and maintain machinery and equipment as well as EGMs in production and finished goods held for sale. Inventories are stated at net realizable value. Cost of inventories is determined using the first-in, first-out (“FIFO”) method for all components of inventory. The Company regularly reviews inventory quantities and updates estimates for the net realizable value of inventories. This process includes examining the carrying values of parts and ancillary equipment in comparison to the current fair market values for such equipment (less costs to sell or dispose). Some of the factors involved in this analysis include the overall levels of the inventories, the current and projected sales levels for such products, the projected markets for such products and the costs required to sell the products, including refurbishment costs. Changes in the assumptions or estimates could materially affect the inventory carrying value.


6

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Property and Equipment

The cost of gaming equipment, consisting of gaming equipment as well as other property and equipment, is depreciated over their estimated useful lives, using the straight-line method for financial reporting. The Company capitalizes costs incurred for the refurbishment of used gaming equipment that is typically incurred to refurbish a machine in order to return it to its customer location. The refurbishments extend the life of the gaming equipment beyond the original useful life. Repairs and maintenance costs are expensed as incurred. The Company routinely evaluates the estimated lives used to depreciate assets. The estimated useful lives are as follows:
Gaming equipment
3 to 6 years
Other property and equipment
1 to 6 years
 

The Company reviews its property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company groups long-lived assets for impairment analysis at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities, which is typically at the individual gaming machine level or at the cabinet product line level. Impairment testing is performed and losses are estimated when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets’ carrying amount.

When the estimated undiscounted cash flows are not sufficient to recover the asset’s carrying amount, an
impairment loss is measured to the extent the fair value of the asset is less than its carrying amount.

The Company measures recoverability of assets to be held and used by comparing the carrying amount of an asset to future cash flows expected to be generated by the asset. The Company’s policy is to impair, when necessary, excess or obsolete gaming machines on hand that it does not expect to be used. Impairment is based upon several factors, including estimated forecast of gaming machine demand for placement into casinos. While the Company believes that the estimates and assumptions used in evaluating the carrying amount of these assets are reasonable, different assumptions could affect either the carrying amount or the estimated useful lives of the assets, which could have a significant impact on the results of operations and financial condition.

Intangible Assets

The Company reviews its identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment losses are recognized for identifiable intangibles, other than goodwill, when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets’ carrying amount.

When the estimated undiscounted cash flows are not sufficient to recover the intangible asset’s carrying amount, an impairment loss is measured to the extent the fair value of the asset is less than its carrying amount.

Certain trade names have an indefinite useful life and the Company tests these trade names for possible impairment at least annually, as of October 1, or whenever events or changes in circumstances indicate that the carrying value may be impaired. We perform a qualitative assessment to determine if it is more likely than not that the fair value of the asset is less than its carrying amount. If we believe, as a result of our qualitative assessment, that it is more likely than not that the fair value of the asset is less than its carrying amount, the quantitative impairment test is required.

Costs of Computer Software

Internally developed gaming software represents the Company’s internal costs to develop gaming titles to utilize on the Company’s gaming machines. Internally developed gaming software is stated at cost and amortized over the estimated useful lives of the software, using the straight-line method. Software development costs are capitalized once technological feasibility has been established and are amortized when the software is placed into service. The computer software we develop reaches technological feasibility when a working model of the computer software is available. Any subsequent software maintenance costs, such as bug fixes and subsequent testing, are expensed as incurred. Discontinued software development costs are expensed when the determination to discontinue is made. Software development costs are amortized over the expected life of the title or group of titles, if applicable, to amortization expense.

7

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


On a quarterly basis, or more frequently if circumstances warrant, the Company compares the net book value of its internally developed computer software to the net realizable value on a title or group of title basis. The net realizable value is determined based upon certain assumptions, including the expected future revenues and net cash flows of the gaming titles or group of gaming titles utilizing that software, if applicable.

Goodwill

The excess of the purchase price of an acquired business over the estimated fair value of the assets acquired and the liabilities assumed is recorded as goodwill. The Company tests for possible impairment of goodwill at least annually, on October 1, or when circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. The Company has the option to begin with a qualitative assessment, commonly referred to as “Step 0”, to determine whether it is more likely than not that the reporting unit’s fair value of goodwill is less than its carrying value. This qualitative assessment may include, but is not limited to, reviewing factors such as the general economic environment, industry and market conditions, changes in key assumptions used since the most recently performed valuation and overall financial performance of the reporting units. If the Company determines that it is more likely than not that a reporting unit’s fair value is less than its carrying value, the Company performs a quantitative goodwill impairment analysis, and depending upon the results of that measurement, the recorded goodwill may be written down and charged to income from operations when its carrying amount exceeds its estimated fair value. As of September 30, 2017, there were no indicators of impairment.

Acquisition Accounting

The Company applies the provisions of ASC 805, “Business Combinations” (ASC 805), in accounting for business acquisitions. It requires us to recognize separately from goodwill the fair value of assets acquired and liabilities assumed on the acquisition date. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. Significant estimates and assumptions are required to value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable. These estimates are inherently uncertain and subject to refinement and typically include the calculation of an appropriate discount rate and projection of the cash flows associated with each acquired asset. As a result, during the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the consolidated statements of operations.

Fair Value of Financial Instruments

The Company applies the provisions of ASC 820, “Fair Value Measurements” (ASC 820) to its financial assets and liabilities. Fair value is defined as a market-based measurement intended to estimate the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. ASC 820 also established a fair value hierarchy, which requires an entity to maximize the use of observable inputs when measuring fair value. These inputs are categorized as follows:

Level 1 - quoted prices in an active market for identical assets or liabilities;
Level 2 - quoted prices in an active market for similar assets or liabilities, inputs other than quoted prices that are observable for similar assets or liabilities, inputs derived principally from or corroborated by observable market data by correlation or other means; and
Level 3 - valuation methodology with unobservable inputs that are significant to the fair value measurement.

The carrying values of the Company’s cash and cash equivalents, restricted cash, receivables and accounts payable approximate fair value because of the short term maturities of these instruments. The fair value of our long-term debt is based on the quoted market prices for similar issues (Level 2 inputs). The estimated fair value of our long-term debt as of September 30, 2017 and December 31, 2016 was $603.4 million and $557.8 million, respectively.


8

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Accounting for Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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 of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that included the enactment date. Future tax benefits are recognized to the extent that realization of those benefits is considered more likely than not, and a valuation allowance is established for deferred tax assets which do not meet this threshold.

Contingencies

The Company assesses its exposures to loss contingencies including claims and legal proceedings and accrues a liability if a potential loss is considered probable and the amount can be estimated. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Because of uncertainties related to these matters, if the actual loss from a contingency differs from management’s estimate, there could be a material impact on the results of operations or financial position. Operating expenses, including legal fees, associated with contingencies are expensed when incurred.

Foreign Currency Translation

The financial statements of the Company’s foreign subsidiaries are translated into U.S. dollars at the period end rate of exchange for asset and liability accounts and the weighted average rate of exchange for income statement accounts. The effects of these translations are recorded as a component of other accumulated comprehensive loss in stockholders’ equity.

Recently Issued Accounting Pronouncements

In May 2014, the FASB issued an accounting standards update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which clarifies the principles for recognizing revenue from contracts with customers. The amendment outlines a single comprehensive model for entities to depict the transfer of goods or services to customers in amounts that reflect the payment to which a company expects to be entitled in exchange for those goods or services. The amendment also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the effective date of ASU 2014-09 to annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2017. The ASU may be adopted using either a full retrospective transition method or a modified retrospective transition method and will be adopted by the Company on January 1, 2018. The Company will use the modified retrospective application approach and does not expect adoption of the new revenue standards to have a material impact on its consolidated financial statements as the majority of our revenue is recognized under lease accounting guidance.

In July 2015, the FASB issued ASU No. 2015-11, Inventory: Simplifying the Measurement of Inventory. ASU 2015-11 changes the criteria for measuring inventory within the scope of the ASU. Inventory will now be measured at net realizable value, while the concept of market value will be eliminated. The ASU defines net realizable value as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. ASU 2015-11 is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. This ASU did not have a material effect on our financial condition, results of operations or cash flows.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 intends to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The adoption of this guidance is expected to result in a significant portion of our operating leases, where we are the lessee, to be recognized on our Consolidated Balance Sheets. The guidance requires lessees and lessors to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years with earlier adoption permitted. The Company is currently evaluating the provisions of the amendment and the impact on its future consolidated financial statements.

9

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). ASU 2016-15 intends to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the provisions of ASU 2016-15 to have a material effect on our financial condition, results of operations or cash flows.    

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. The new guidance clarifies the definition of a business in order to allow for the evaluation of whether transactions should be accounted for as acquisitions or disposals of assets or businesses. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, with early adoption permitted. We are currently evaluating the impact of adopting this guidance.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Under the new amendments, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value. We adopted this guidance prospectively at the beginning of first quarter 2017, which will simplify our future goodwill impairment testing.

We do not expect that any other recently issued accounting guidance will have a significant effect on our financial statements.

NOTE 2. ACQUISITIONS

Intellectual Property Acquisitions

During the quarter ended September 30, 2017, the Company acquired certain intangible assets related to the purchase of table games and table game related intellectual property.  The acquisition was accounted for as an acquisition of a business and the assets acquired and liabilities assumed were measured based on our preliminary estimates of their fair values at the acquisition date. The estimated fair values of assets acquired and liabilities assumed and resulting goodwill are subject to adjustment as we finalize our fair value analysis.  We attribute the goodwill acquired to our ability to commercialize the products over our distribution and sales network, opportunities for synergies, and other strategic benefits.  Total consideration of $9.5 million included an estimated $2.5 million of contingent consideration that is payable upon the achievement of certain targets and periodically based on a percentage of product revenue earned on the purchased table games.  The consideration was allocated primarily to tax deductible goodwill for $4.4 million and intangible assets of $4.2 million, which will be amortized over a weighted average period of approximately 9 years.

The contingent consideration was valued using scenario-based methods (level 3 fair value measurement) that account for the expected timing of payments to be made and discounted using an estimated borrowing rate.  The borrowing rate utilized for this purpose was developed with reference to the Company’s existing borrowing rates, adjusted for the facts and circumstances related to the contingent consideration.

The intangible assets consist of a primary asset that includes the intellectual property acquired, which asset represents the majority of the intangible asset value.  This intellectual property was valued using the excess earnings method (level 3 fair value measurement), which is a risk-adjusted discounted cash flow approach that determines the value of an intangible asset as the present value of the cash flows attributable to such asset after excluding the proportion of the cash flows that are attributable to other assets. The contribution to the cash flows that are made by other assets - such as working capital, workforce and other intangible assets - was estimated through contributory asset capital charges. The value of the acquired intellectual property is the present value of the attributed post-tax cash flows, net of the post-tax return on fair value attributed to the other assets.

10

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


NOTE 3. PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Gaming equipment
$
125,082

 
$
108,635

Other property and equipment
16,325

 
13,900

Less: Accumulated depreciation
(65,946
)
 
(54,609
)
Total property and equipment, net
$
75,461

 
$
67,926


Gaming equipment and other property and equipment are depreciated over the respective useful lives of the assets ranging from one to six years. Depreciation expense was $7.1 million and $6.5 million for the three months ended September 30, 2017 and 2016, respectively. Depreciation expense was $19.9 million and $21.0 million for the nine months ended September 30, 2017 and 2016, respectively.
NOTE 4. GOODWILL AND INTANGIBLES
There were no accumulated impairments of goodwill as of September 30, 2017. Changes in the carrying amount of goodwill are as follows (in thousands):
 
Gross Carrying Amount
 
EGM
 
Table Products
 
Interactive
 
Total
Balance at December 31, 2016
$
242,796

 
$
3,400

 
$
4,828

 
$
251,024

Foreign currency adjustments
2,380

 

 

 
2,380

Acquisition

 
4,441

 

 
4,441

Balance at September 30, 2017
$
245,176

 
$
7,841

 
$
4,828

 
$
257,845


Intangible assets consist of the following (in thousands):
 
 
 
September 30, 2017
 
December 31, 2016
 
Useful Life (years)
 
Gross
Value
 
Accumulated
Amortization
 
Net Carrying
Value
 
Gross
Value
 
Accumulated
Amortization
 
Net Carrying
Value
Indefinite lived trade names
Indefinite
 
$
12,126

 
$

 
$
12,126

 
$
12,126

 
$

 
$
12,126

Trade and brand names
3 - 5
 
13,800

 
(6,883
)
 
6,917

 
13,600

 
(4,671
)
 
8,929

Customer relationships
5 - 12
 
167,410

 
(64,857
)
 
102,553

 
165,078

 
(49,528
)
 
115,550

Contract rights under development and placement fees
1 - 7
 
16,692

 
(8,728
)
 
7,964

 
16,488

 
(5,235
)
 
11,253

Gaming software and technology platforms
2 - 7
 
133,143

 
(63,356
)
 
69,787

 
123,596

 
(49,014
)
 
74,582

Intellectual property
3 - 10
 
15,880

 
(3,459
)
 
12,421

 
12,780

 
(2,343
)
 
10,437

 
 
 
$
359,051

 
$
(147,283
)
 
$
211,768

 
$
343,668

 
$
(110,791
)
 
$
232,877

 

Intangible assets are amortized over their respective estimated useful lives ranging from one to twelve years. Amortization expense related to intangible assets was $9.9 million and $12.9 million for the three months ended September 30, 2017 and 2016, respectively. Amortization expense related to intangible assets was $33.7 million and $39.5 million for the nine months ended September 30, 2017 and 2016, respectively.

The Company enters into development agreements and placement fee agreements with certain customers to secure floor space under lease agreements for its gaming machines. Amounts paid in connection with the development agreements are repaid to the Company in accordance with the terms of the agreement, whereas placements fees are not reimbursed. For development agreements in the form of a loan, interest income is recognized on the repayment of the notes based on the stated

11

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

rate or, if not stated explicitly in the development agreement, on an imputed interest rate. If the stated interest rate is deemed to be other than a market rate or zero, a discount is recorded on the note receivable as a result of the difference between the stated and market rate and a corresponding intangible asset is recorded. The intangible asset is recognized in the financial statements as a contract right under development agreement and amortized as a reduction in revenue over the term of the agreement. Placement fees can be in the form of cash paid upfront or free lease periods and are accreted over the life of the contract and the expense is recorded as a reduction of revenue. We recorded a reduction of gaming operations revenue from the accretion of contract rights under development agreements and placement fees of $1.2 million and $1.2 million for the three months ended September 30, 2017 and 2016, respectively. We recorded a reduction of gaming operations revenue from the accretion of contract rights under development agreements and placement fees of $3.5 million and $3.5 million for the nine months ended September 30, 2017 and 2016, respectively.
NOTE 5. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Salary and payroll tax accrual
$
6,601

 
$
6,594

Taxes payable
2,790

 
2,128

Accrued interest
4,064

 
2

License fee obligation
1,000

 

Placement fees payable
4,000

 
4,000

Accrued other
4,550

 
4,978

Total accrued liabilities
$
23,005

 
$
17,702

 

NOTE 6. LONG-TERM DEBT

Long-term debt consists of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
First Lien Credit Facilities:
 
 
 
Term loans, interest at LIBOR or base rate plus 5.50% (6.74% at September 30, 2017), net of unamortized discount and deferred loan costs of $13.7 million at September 30, 2017.
$
435,150

 
$

Senior secured PIK notes, net of unamortized discount and deferred loan costs of $3.2 million and $3.5 million at September 30, 2017 and December 31, 2016, respectively.
141,328

 
133,286

Equipment long-term note payable and capital leases
3,264

 
4,792

Senior secured credit facilities:
 
 
 
Term loans, interest at LIBOR or base rate plus 8.25% , net of unamortized discount and deferred loan costs of $15.1 million at December 31, 2016.

 
395,581

Seller notes

 
20,116

Total debt
579,742

 
553,775

Less: Current portion
(6,674
)
 
(6,537
)
Long-term debt
$
573,068

 
$
547,238


First Lien Credit Facilities

On June 6, 2017 (the “Closing Date”), AP Gaming I, LLC (the “Borrower”), a wholly owned indirect subsidiary of the Company, entered into a first lien credit agreement, providing for $450.0 million in term loans and a $30.0 million revolving credit facility (the “First Lien Credit Facilities”).  The proceeds of the term loans were used primarily to repay the Existing Credit Facilities (as defined below), the AGS Seller Notes (as defined below) and the Amaya Seller Note (as defined below), to pay for the fees and expenses incurred in connection with the foregoing and otherwise for general corporate purposes.


12

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The term loans will mature on February 15, 2024, and the revolving credit facility will mature on June 6, 2022. Starting with the first full quarter after the Closing Date, the term loans require scheduled quarterly payments in amounts equal to 0.25% of the original aggregate principal amount of the term loans, with the balance due at maturity.  Borrowings under the term loans bear interest at a rate equal to, at the Borrower’s option, either LIBOR or the base rate, subject to an interest rate floor plus an applicable margin rate.  Borrowings under the revolving credit facility bear interest at a rate equal to, at the Borrower’s option, either LIBOR or the base rate plus an applicable margin rate.  In addition, on a quarterly basis, the Borrower is required to pay each lender under the revolving credit facility a commitment fee in respect of any unused commitments thereunder at a rate of 0.50% per annum.

The First Lien Credit Facilities are guaranteed by AP Gaming Holdings, LLC, the Borrower’s material, wholly owned domestic subsidiaries (subject to certain exceptions), and are secured by a pledge by AP Gaming Holdings, LLC of the Borrower’s equity interest directly held by AP Gaming Holdings, LLC and a pledge of substantially all of the existing and future property and assets of the Borrower and the subsidiary guarantors, subject to certain exceptions.  The First Lien Credit Facilities require that the Borrower maintain a maximum net first lien leverage ratio set at a maximum of 6.0 to 1.0

The First Lien Credit Facilities also contain customary affirmative covenants and negative covenants that limit our ability to, among other things: (i) incur additional debt or issue certain preferred shares; (ii) create liens on certain assets; (iii) make certain loans or investments (including acquisitions); (iv) pay dividends on or make distributions in respect of our capital stock or make other restricted payments; (v) consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; (vi) sell assets; (vii) enter into certain transactions with our affiliates; (viii) enter into sale-leaseback transactions; (ix) change our lines of business; (x) restrict dividends from our subsidiaries or restrict liens; (xi) change our fiscal year; and (xii) modify the terms of certain debt or organizational agreements. The new senior secured credit facilities also contain customary events of default included in similar financing transactions, including, among others, failure to make payments when due, default under other material indebtedness, breach of covenants, breach of representations and warranties, involuntary or voluntary bankruptcy, and material judgments.

Amended and Restated Senior Secured PIK Notes

On May 30, 2017, the Company entered into an amended and restated note purchase agreement (the “A&R Note Purchase Agreement”) with AP Gaming Holdings, LLC, as subsidiary guarantor (the “Subsidiary Guarantor”), Deutsche Bank AG, London Branch, as holder (the “Holder”), and Deutsche Bank Trust Company Americas, as collateral agent, which amended and restated the note purchase agreement, dated as of May 29, 2015.

The A&R Note Purchase Agreement governs the Company’s previously issued 11.25% senior secured PIK notes (the “Notes”), $115.0 million of which had been issued to the Holder at an issue price of 97% of the principal amount thereof to the Holder in a private placement exempt from registration under the Securities Act of 1933, as amended.  The A&R Note Purchase Agreement extends the maturity of the Notes to May 28, 2024 and modifies the terms of the Notes to, among other things, account for the repayment of the AGS Seller Notes and the Amaya Seller Note.

The Notes remain secured by the Company’s equity in its subsidiary AP Gaming, Inc., subject to certain limitations including those imposed by gaming laws, and are unconditionally guaranteed by the Subsidiary Guarantor. Interest on the Notes continues to accrue at a rate of 11.25% per annum.  The Company may elect to pay interest due on the Notes in cash, by increasing the principal of the outstanding Notes or by issuing new Notes (“PIK interest”) for the entire amount of the interest payment or by paying interest partially in cash and partially in PIK interest.  Interest on the Notes accrues from the date of issuance and is payable on the dates described in more detail in the A&R Note Purchase Agreement.

The Notes contain limitations on additional indebtedness, guarantees, incurrence of liens, investments and distributions, as defined, some of which were modified in the A&R Note Purchase Agreement.  The Notes also contains customary events of default included in similar transactions, including, among others, failure to make payments when due, acceleration of other material indebtedness, breach of covenants, breach of representations and warranties, involuntary or voluntary bankruptcy, and material judgments.

Equipment Long Term Note Payable and Capital Leases

The Company has entered into a financing agreement to purchase certain gaming devices, systems and related equipment and has entered into leases for servers and equipment that are accounted for as capital leases.

13

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


Senior Secured Credit Facilities

On June 6, 2017, the Borrower terminated its senior secured credit facilities (the “Existing Credit Facilities”), dated as of December 20, 2013 (as amended as of May 29, 2015 and as of June 1, 2015 and as amended, restated, supplemented or otherwise modified prior to June 6, 2017), by and among the Borrower, the lenders party thereto from time to time and Citicorp North America, Inc., as administrative agent. In connection with the termination, the Borrower repaid all of the outstanding obligations in respect of principal, interest and fees under the Existing Credit Facilities.

On June 6, 2017, net deferred loan costs and discounts totaling $13.9 million related to the Existing Credit Facilities were capitalized and were being amortized over the term of the agreement. In conjunction with the refinancing, approximately $3.3 million of these deferred loan costs and discounts was written off as a portion of the loss on extinguishment and modification of debt and the remainder of these cost will be amortized over the term of the First Lien Credit Facilities. An additional $9.2 million in loan costs and discounts was incurred related to the issuance of the First Lien Credit Facilities. Given the composition of the lender group, certain lenders were accounted for as a debt modification and, as such, $4.8 million in debt issuance costs related to the First Lien Credit Facilities were expensed and included in the loss on extinguishment and modification of debt, the remaining amount was capitalized and will be amortized over the term of the agreement. 

Seller Notes

On June 6, 2017, AP Gaming, Inc., a wholly owned subsidiary of the Company terminated two promissory notes issued by AP Gaming, Inc. to AGS Holdings, LLC, in the initial principal amounts of $2.2 million and $3.3 million, respectively (the “AGS Seller Notes”). The AGS Seller Notes had been issued to the previous owners of the Company’s primary operating company. In connection with the termination, the Company caused the repayment all of the outstanding obligations in respect of principal and interest under the AGS Seller Notes.

On the June 6, 2017, the Company terminated a promissory note issued by the Company to Amaya Inc. (the “Amaya Seller Note”) with an initial principal amount of $12.0 million. The Amaya Seller Note had been issued to satisfy the conditions set forth in the stock purchase agreement for Amaya Americas Corporation (“Cadillac Jack”). During the quarter ended March 31, 2017, the Amaya Seller Note was reduced by $5.1 million to settle a clause from the Stock Purchase Agreement allowing for a refund if certain deactivated gaming machines in Mexico were not in operation as of a specified date. In connection with the termination, the Company repaid all outstanding obligations in respect of principal and interest under the Amaya Seller Note.

NOTE 7. STOCKHOLDERS’ EQUITY

Common Stock

The Company’s common stock consists of two classes: class A voting common stock (“Class A Shares”) and class B non-voting common stock (“Class B Shares”). The holders of the Class A Shares are entitled to one vote per share on all matters to be voted on by the stockholders of the Company. The holders of the Class A Shares have no economic rights or privileges, including rights in liquidation, and have no right to receive dividends or any other distributions. The holders of the Class B Shares have no right to vote on any matter to be voted on by the stockholders of the Company. Each holder of Class B Shares is entitled to share equally, share for share, dividends declared, as well as any distributions to the stockholders, and in the event of the Company’s liquidation, dissolution or winding up, is entitled to share ratably in any remaining assets after payment of or provision for liabilities and the liquidation on preferred stock, if any.

As of September 30, 2017, 109,832 Class B Shares issued to “Management Holder,” as defined in the Securityholders Agreement dated April 28, 2014 (the “Securityholders Agreement”), were outstanding. The Class B Shares were sold to the Management Holder and are not considered issued for accounting purposes as they contain a substantive performance condition, a “Qualified Public Offering”, as defined in the Securityholders Agreement, which must be probable for the Management Holder to benefit from the ownership of the shares. As a result, shares issued to the Management Holder are not considered issued for accounting purposes until such time that the performance condition is probable and the Company has recorded a liability in other long-term liabilities of $1.3 million for the proceeds from the sale of the Class B Shares. No share-based compensation expense for Class B Shares has been recognized and none will be recognized for these shares until the performance condition is considered to be probable.

14

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)


Class B Shares that are held by a Management Holder are subject to repurchase rights (the “Repurchase Rights”), as outlined in Section 6 of the Securityholders Agreement, that are contingent on the Management Holder’s termination. The Repurchase Rights enable the Company to recover the Class B Shares issued to Management Holders without transferring any appreciation of the fair value of the stock to the Management Holder upon certain terminations of the Management Holder’s employment prior to a “Qualified Public Offering”, as defined in the Securityholders Agreement. If a Management Holder’s employment is terminated by the Company prior to the consummation of a Qualified Public Offering for “Cause”, as defined in the Securityholders Agreement, or is terminated by such Management Holder without “Good Reason”, as defined in the Securityholders Agreement, then the Company shall have the right to repurchase all or any portion of the Class B Shares held by such Management Holder for the lesser of original cost and fair market value. If a Management Holder’s employment is terminated by the Company prior to the consummation of a Qualified Public Offering other than as described above and in the Securityholders Agreement, then the Company shall have the right to repurchase all or any portion of the Class B Shares held by such Management Holder for fair market value.

NOTE 8. WRITE DOWNS AND OTHER CHARGES

The Condensed Consolidated Statements of Operations and Comprehensive Loss include various non-routine transactions or consulting and transaction-related fees that have been classified as write downs and other charges. During the three months ended September 30, 2017, the Company recognized $0.5 million in write-downs and other charges driven by losses from the disposal of assets. During the nine months ended September 30, 2017, the Company recognized $2.7 million in write-downs and other charges driven by losses from the disposal of assets of $3.0 million, the full impairment of certain intangible assets of $0.3 million (level 3 fair value measurement based on projected cash flows for the specific game titles), offset by a fair value adjustment to an acquisition contingent receivable of $0.6 million (level 3 fair value measurements based on projected cash flows). The contingency was resolved in the quarter ending March 31, 2017. See Item 1. “Financial Statements” Note 6 for a detailed discussion regarding the resolution of the contingency described above.

During the three months ended September 30, 2016, the company recognized $1.9 million in write-downs and other charges, driven by a $3.3 million impairment of an intangible asset related to a customer contract that will provide less benefit than originally estimated from the Cadillac Jack acquisition (a level 3 fair value measurement based on a decrease in projected cash flows). The value of the intangible asset was written down to $1.1 million at an interim date and subsequently fully amortized by December 31, 2016. Additionally a write-down of long-lived assets of $1.3 million related to older generation gaming machines (level 3 fair value measurement based on projected cash flow for the specific assets) in which the long-lived assets were written down to $0, and losses from the disposal of assets of $0.2 million. These charges were offset by a $3.0 million fair value adjustment to a contingent consideration receivable related to the Cadillac Jack acquisition (level 3 fair value measurements based on expected and probable future realization of the receivable).

During the nine months ended September 30, 2016, the Company recognized $2.2 million in write-downs and other charges, driven by a $3.3 million impairment of an intangible asset related to a customer contract that will provide less benefit than originally estimated from the Cadillac Jack acquisition (a level 3 fair value measurement based on a decrease in projected cash flows). The value of the intangible asset was written down to $1.1 million at an interim date and subsequently fully amortized by December 31, 2016. Additionally, a write-down of long-lived assets of $1.3 million related to aged gaming machines (level 3 fair value measurements based on projected cash flows), and losses from the disposal of assets of $0.6 million. These charges were offset by a $3.0 million fair value adjustment to a contingent consideration receivable related to the Cadillac Jack acquisition.

Due to the changing nature of our write downs and other charges, we describe the composition of the balances as opposed to providing a year over year comparison.


15

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

NOTE 9. BASIC AND DILUTED INCOME (LOSS) PER SHARE

The Company computes net income (loss) per share in accordance with accounting guidance that requires presentation of both basic and diluted earnings per share (“EPS”) on the face of the Condensed Consolidated Statement of Operations and Comprehensive Income (Loss). Basic EPS is computed by dividing net income (loss) for the period by the weighted average number of shares outstanding during the period. Basic EPS excludes Class A shares and Class B Shares issued to Management Holders until the performance condition or termination event is considered probable (see Note 7). Until such time, the Class B Shares issued to Management Holders will be included in the calculation of diluted EPS using the treasury stock method and are treated as stock options. Diluted EPS is computed by dividing net income (loss) for the period by the weighted average number of common shares outstanding during the period, increased by potentially dilutive common shares that were outstanding during the period. Diluted EPS excludes all potential dilutive shares if their effect is anti-dilutive. Potentially dilutive common shares include stock options and restricted stock (see Note 11).

There were no potentially dilutive securities for the three and nine months ended September 30, 2017.

Excluded from the calculation of diluted EPS for the three months ended September 30, 2017 was 50,000 restricted shares and 0.2 million stock options, as such securities were anti-dilutive. Excluded from the calculation of diluted EPS for the nine months ended September 30, 2017 was 50,000 restricted shares and 0.3 million stock options, as such securities were anti-dilutive. Excluded from the calculation of diluted EPS for the three and nine months ended September 30, 2016 was 50,000 restricted shares and 0.3 million stock options, as such securities were anti-dilutive.
NOTE 10. BENEFIT PLANS
The Company has established a 401(k) plan (the “401(k) Plan”) for its employees. The 401(k) Plan allows employees to contribute a portion of their earnings, and the Company may match a percentage of the contributions on a discretionary basis. The expense associated with the 401(k) Plan for the three months ended September 30, 2017 and 2016, was $0.2 million and $0.2 million, respectively. The expense associated with the 401(k) Plan for the nine months ended September 30, 2017 and 2016, was $0.8 million and $0.7 million, respectively.
On April 28, 2014, the board of directors of the Company approved the 2014 Long-Term Incentive Plan (“LTIP”). Under the LTIP, the Company is authorized to grant nonqualified stock options, rights to purchase Class B Shares, restricted stock, restricted stock units and other awards settleable in, or based upon, Class B Shares to persons who are directors and employees of and consultants to the Company or any of its subsidiaries on the date of the grant. The LTIP will terminate ten years after approval by the board. Subject to adjustments in connection with certain changes in capitalization, the maximum number of Class B Shares that may be delivered pursuant to awards under the LTIP is 1,450,000. As of September 30, 2017, approximately 0.2 million shares remain available for issuance.

NOTE 11. SHARE-BASED COMPENSATION

Stock Options

The Company has granted stock awards to eligible participants under the LTIP. The stock awards include options to purchase the Company’s Class B Shares. These stock options include a combination of service and market conditions, as further described below. In addition, these stock options include a performance vesting condition, a Qualified Public Offering (see Note 7), which was not considered to be probable as of September 30, 2017. As a result, no share-based compensation expense for stock options has been recognized and none will be recognized for these stock awards until the performance condition is considered to be probable. The amount of unrecognized compensation expense associated with stock options was $7.7 million and for restricted stock was $0.5 million at September 30, 2017. When the performance condition is considered probable, the stock awards will vest in accordance with the underlying service and market conditions.

The Company calculated the grant date fair value of stock options that vest over a service period using the Black Scholes model. For stock options that contain a market condition related to the return on investment that the Company’s stockholders achieve, the options were valued using a lattice-based option valuation model. The assumptions used in these calculations are noted in the following table. Expected volatilities are based on implied volatilities from comparable companies. The expected time to liquidity is based on management’s estimate. The risk-free rate is based on the U.S. Treasury yield curve for a term equivalent to the estimated time to liquidity.

16

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

 
Nine months ended September 30,
 
2017
 
2016
Option valuation assumptions:
 
 
 
Expected dividend yield
—%
 
—%
Expected volatility
66%
 
55%
Risk-free interest rate
1.80%
 
1.67%
Expected term (in years)
6.2
 
6.3

Stock option awards represent options to purchase Class B Shares and are granted pursuant to the Company’s LTIP, and include options that the Company primarily classifies as Tranche A, Tranche B and Tranche C.

Tranche A options are eligible to vest in equal installments of 20% on each of the first five anniversaries of the date of the grant, subject to continued employment with the Company or its subsidiaries. In the event of a termination of employment without cause or as a result of death or disability, any such time based options which would have vested on the next applicable vesting date shall become vested, and the remaining unvested time based options shall be forfeited. In addition, upon a Change in Control (as defined in the Company’s 2014 Long-Term Incentive Plan), subject to continued employment through the date of the Change in Control, all outstanding unvested time based options shall immediately vest. An initial public offering does not qualify as a Change in Control as it relates to the vesting of stock options.

All other option awards are eligible to vest upon the satisfaction of certain performance conditions (collectively, “Performance Options”). Tranche B options are eligible to vest based on achievement of an Investor IRR equal to or in excess of 20%, subject to a minimum cash-on-cash return of 2.5 times the Investor Investment (as such terms are defined in the Company’s 2014 Long-Term Incentive Plan). Tranche C options are eligible to vest based on achievement of an Investor IRR equal to or in excess of 25%, subject to a minimum cash-on-cash return of 3.0 times the Investor Investment. In the event of a termination of employment without cause or as a result of death or disability, any Performance Options which are outstanding and unvested will remain eligible to vest subject to achievement of such performance targets (without regard to the continued service requirement) until the first anniversary of the date of such termination. As of September 30, 2017, the Company had 0.4 million Performance Options outstanding.

A summary of the changes in stock options outstanding during the nine months ended September 30, 2017, is as follows:
 
Number of Options
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contract Term (years)
 
Aggregate Intrinsic Value
Options outstanding as of December 31, 2016
895,100
 
$13.35
 

 


Granted
224,750
 
$15.91
 
 
 
 
Canceled
(35,000)
 
$16.98
 
 
 
 
Options outstanding as of September 30, 2017
1,084,850
 
$13.76
 
7.8
 
$
2,479,475


Restricted Stock

No restricted stock was granted, canceled or forfeited during the nine months ended September 30, 2017. There were no changes to outstanding restricted stock awards during the nine months ended September 30, 2017.

NOTE 12. INCOME TAXES

The Company's effective income tax rate for the three months ended September 30, 2017, was an expense of 34.6%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the three months ended September 30, 2017, was primarily due to changes in our valuation allowance on deferred tax assets. The Company's effective income tax rate for the three months ended September 30, 2016, was a benefit of 5.2%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the three months ended September 30, 2016, was primarily due to changes in our valuation allowance on deferred tax assets.


17

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The Company's effective income tax rate for the nine months ended September 30, 2017, was an expense of 14.4%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2017, was primarily due to changes in our valuation allowance on deferred tax assets. The Company's effective income tax rate for the nine months ended September 30, 2016, was a benefit of 7.5%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2016, was primarily due to an increase in our valuation allowance on deferred tax assets.
NOTE 13. COMMITMENTS AND CONTINGENCIES
The Company is subject to federal, state and Native American laws and regulations that affect both its general commercial relationships with its Native American tribal customers, as well as the products and services provided to them. Periodically, the Company reviews the status of each significant matter and assesses the potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, the Company accrues a liability for the estimated loss. If a potential loss from any claim or legal proceeding is considered reasonably possible, the Company discloses an estimate of the possible loss or range of possible loss, or a statement that such an estimate cannot be made. There are no matters that meet the criteria for disclosure outlined above. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, the Company reassesses the potential liability related to their pending claims and litigation and may revise their estimates. Such revisions in the estimates of the potential liabilities could have a material impact on the results of operations and financial condition.

18

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

NOTE 14. OPERATING SEGMENTS

We report our business segment results by segment in accordance with the “management approach.” The management approach designates the internal reporting used by our chief operating decision maker, who is our Chief Executive Officer, for making decisions and assessing performance of our reportable segments.

See Note 1 for a detailed discussion of our three segments. Each segment’s activities include the design, development, acquisition, manufacturing, marketing, distribution, installation and servicing of its product lines. We evaluate the performance of our operating segments based on revenues and segment adjusted EBITDA.

Segment revenues include leasing, licensing, or selling of products within each reportable segment. Segment adjusted EBITDA includes the revenues and operating expenses from each segment adjusted for depreciation, amortization, write downs and other charges, accretion of placement fees, non-cash stock compensation expense, as well as other costs such as certain acquisitions and integration related costs including restructuring and severance charges; legal and litigation expenses including settlement payments; new jurisdictions and regulatory licensing costs; non-cash charges on capitalized installation and delivery; contract cancellation fees; and other adjustments primarily composed of professional fees incurred by the Company for projects, corporate and public filing compliance and other costs deemed to be non-recurring in nature. Revenues in each segment are attributable to third parties and segment operating expenses are directly associated with the product lines included in each segment such as research and development, product approval costs, product-related litigation expenses, sales commissions and other directly-allocable sales expenses. Cost of gaming operations and cost of equipment sales primarily include the cost of products sold, service, manufacturing overhead, shipping and installation.

Segment adjusted EBITDA excludes other income and expense, income taxes and certain expenses that are managed outside of the operating segments.


19

AP GAMING HOLDCO INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following provides financial information concerning our reportable segments for the three and nine months ended September 30,:     
 
Three months ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues by segment
 
 
 
 
 
 
 
EGM
$
53,331

 
$
38,377

 
$
145,747

 
$
116,153

Table Products
1,099

 
674

 
2,442

 
2,005

Interactive
2,010

 
2,157

 
6,105

 
5,903

Total Revenues
$
56,440

 
$
41,208

 
$
154,294

 
$
124,061

Adjusted EBITDA by segment
 
 
 
 
 
 
 
EGM
29,756

 
20,943

 
81,450

 
68,704

Table Products
(232
)
 
(380
)
 
(721
)
 
(1,395
)
Interactive
(123
)
 
(607
)
 
(337
)
 
(4,071
)
Subtotal
29,401

 
19,956

 
80,392

 
63,238

Write downs and other:
 
 
 
 
 
 
 
Loss on disposal of long lived assets
490

 
248

 
3,000

 
558

Impairment of long lived assets

 
4,604

 
285

 
4,606

Fair value adjustments to contingent consideration and other items

 
(3,000
)
 
(630
)
 
(3,000
)
Acquisition costs

 

 

 
(11
)
Depreciation and amortization
16,931

 
19,419

 
53,598

 
60,527

Accretion of placement fees(1)
1,192

 
1,190

 
3,492

 
3,538

Acquisitions & integration related costs including restructuring & severance
71

 
2,685

 
899

 
5,034

Legal & litigation expenses including settlement payments
181

 
361

 
766

 
1,495

New jurisdictions and regulatory licensing costs
567

 
842

 
1,304

 
957

Non-cash charge on capitalized installation and delivery
359

 
353

 
1,284

 
1,193

Non-cash charges and loss on disposition of assets

 
285

 
686

 
2,352

Other adjustments
474

 
86

 
2,067

 
1,650

Interest expense
12,666

 
14,903

 
42,380

 
44,151

Interest income
(25
)
 
(12
)
 
(80
)
 
(51
)
Loss on extinguishment and modification of debt

 

 
8,129

 

Other expense (income)
(467
)
 
392

 
(4,805
)
 
6,314

Loss before income taxes
$
(3,038
)
 
$
(22,400
)
 
$
(31,983
)
 
$
(66,075
)
(1) Non-cash item related to the accretion of contract rights under development agreements and placement fees.

The Company’s Chief Operating Decision Maker (the CODM) does not receive a report with a measure
of total assets or capital expenditures for each reportable segment as this information is not used for the evaluation of segment performance. The CODM assesses the performance of each segment based on adjusted EBITDA and not based on assets or capital expenditures due to the fact that two of the Company’s reportable segments, Table Products and Interactive, are not capital intensive. Any capital expenditure information is provided to the CODM on a consolidated basis. Therefore, the Company has not provided asset and capital expenditure information by reportable segment.
 

20


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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains “forward-looking statements.” Forward-looking statements include any statements that address future results or occurrences. In some cases you can identify forward-looking statements by terminology such as “may,” “might,” “will,” “would,” “should,” “could” or the negatives thereof. Generally, the words “anticipate,” “believe,” “continue,” “expect,” “intend,” “estimate,” “project,” “plan” and similar expressions identify forward-looking statements. In particular, statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance contained elsewhere in this Quarterly Report on Form 10-Q as well as those discussed under “Item 1. Business” and “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year-ended December 31, 2016 are forward-looking statements. These forward-looking statements include statements that are not historical facts, including statements concerning our possible or assumed future actions and business strategies. We have based these forward-looking statements on our current expectations, assumptions, estimates and projections. While we believe these expectations, assumptions, estimates and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks, uncertainties and other factors, many of which are outside of our control, which could cause our actual results, performance or achievements to differ materially from any results, performance or achievements expressed or implied by such forward-looking statements. Given the risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. These forward-looking statements are made only as of the date of this Quarterly Report. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments unless required by federal securities law. New factors emerge from time to time, and it is not possible for us to predict all such factors.
    
Unless the context indicates otherwise, or unless specifically stated otherwise, references to the “Company”, “AP Gaming”, “we,” “our” and “us” refer to AP Gaming Holdco, Inc. and its consolidated subsidiaries.

Overview

We are a designer and supplier of diverse products and services for the gaming industry.  Founded in 2005, our roots are in the Class II Native American gaming market, where we are one of the market leaders in electronic gaming machines (“EGMs”), which include slot machines, video bingo machines, and other electronic gaming devices. Our customers predominantly consist of casino operators in Class II and Class III Native American and commercial gaming enterprises.  Historically, approximately 80% of our total revenue is recurring which refers to Interactive revenue and revenue generated under contracted lease agreements, whereby we place electronic gaming machines (“EGMs”), systems, and table game products at a customer’s facility in return for either a share of the revenues that these products generate, or a daily or monthly fee.  Since mid-2014, we have significantly broadened and diversified our product portfolio through both organic development and strategic acquisitions, and we now offer three distinct categories of products: Electronic Gaming Machines (“EGM”), Table products (“Table Products”), and Interactive Social Casino Games (“Interactive”). Each segment's activities include the design, development, acquisition, manufacturing, marketing, distribution, installation and servicing of a distinct product line.
    
As of September 30, 2017, we had 22,015 EGM units installed under revenue sharing or fee per day agreements. The majority of our systems are used by Native American gaming operators in both Class II and Class III jurisdictions as well as commercial casinos in Mexico. We currently derive a substantial portion of our gaming revenues from lease agreements whereby we place EGMs and systems at a customer’s facility in return for either a share of the revenues that these machines and systems generate or a daily fee.
    
The following points should be noted as they relate to each of our segments:

Electronic Gaming Machines

Our EGM segment is primarily a lease model, and we expect to continue to realize the majority of our EGM revenues through leases in markets such as the United States, and Mexico, as well as other markets that make strategic sense.
We also expect growth in markets such as Latin America and the United States.  In the current year, we have grown our footprint in Latin America and the United States and expect continued growth in these markets.


21


Table Products
The majority of our Table Products segment revenue is derived from royalties and leases primarily in the United States.  We are constantly looking to expand our proprietary table product footprint through the acquisition or development of new games.  
We also pursue opportunities to place Table Products in new properties and jurisdictions in the United States.  In the past few years, several jurisdictions have either opened new casino properties or approved live table games, and we have seen placements of our table products in those new jurisdictions.
We intend to increase our Table Products content through development and acquisition of new proprietary titles. By increasing our footprint with new titles, we hope to increase our market penetration.

Interactive
Currently, our interactive social gaming revenue is generated from a high volume of consumers’ purchases of virtual coins which are used to play the games.
We expect to begin offering business to business (“B2B”) social casino products available to land-based casino customers.
We expect to devote substantial resources to the ongoing maintenance and development of our Interactive gaming segment.

Key Drivers of Our Business

Our revenues are impacted by the following key factors:

the amount of money spent by consumers on our domestic revenue share installed base;
the amount of the daily fee and selling price of our participation electronic gaming machines;
our revenue share percentage with customers;
the capital budgets of our customers;
the level of replacement of existing electronic gaming machines in existing casinos;
expansion of existing casinos;
development of new casinos;
opening of new gaming jurisdictions both in the United States and internationally;
our ability to obtain and maintain gaming licenses in various jurisdictions;
the relative competitiveness and popularity of our electronic gaming machines compared to competitive products offered in the same facilities; and
general macro-economic factors, including levels of and changes to consumer disposable income and personal consumption spending.

Our expenses are impacted by the following key factors:

fluctuations in the cost of labor relating to productivity;
overtime and training;
fluctuations in the price of components for gaming equipment;
fluctuations in energy prices;
changes in the cost of obtaining and maintaining gaming licenses; and
fluctuations in the level of maintenance expense required on gaming equipment.

Variations in our selling, general and administrative expenses, or SG&A, and research and development, or R&D are primarily due to changes in employment and salaries and related fringe benefits.

22



Results of Operations
    
Three Months Ended September 30, 2017 compared to the Three Months Ended September 30, 2016

The following tables set forth certain selected condensed consolidated financial data for the three months ended September 30, 2017 and 2016 (in thousands): 
 
Three months ended September 30,
 
$
 
%
 
2017
 
2016
 
Change
 
Change
Consolidated Statements of Operations:
 
 
 
 
 
 
 
Revenues
 
 
 
 
 
 
 
Gaming operations
$
42,849

 
$
38,877

 
$
3,972

 
10.2
 %
Equipment sales
13,591

 
2,331

 
11,260

 
483.1
 %
Total revenues
56,440

 
41,208

 
15,232

 
37.0
 %
Operating expenses


 


 
 
 
 
Cost of gaming operations
7,344

 
6,711

 
633

 
9.4
 %
Cost of equipment sales
6,330

 
698

 
5,632

 
806.9
 %
Selling, general and administrative
9,742

 
12,970

 
(3,228
)
 
(24.9
)%
Research and development
6,467

 
6,675

 
(208
)
 
(3.1
)%
Write downs and other charges
490

 
1,852

 
(1,362
)
 
(73.5
)%
Depreciation and amortization
16,931

 
19,419

 
(2,488
)
 
(12.8
)%
Total operating expenses
47,304

 
48,325

 
(1,021
)
 
(2.1
)%
Income (loss) from operations
9,136

 
(7,117
)
 
16,253

 
228.4
 %
Other expense (income)
 
 
 
 
 
 
 
Interest expense
12,666

 
14,903

 
(2,237
)
 
(15.0
)%
Interest income
(25
)
 
(12
)
 
(13
)
 
(108.3
)%
Other (income) expense
(467
)
 
392

 
(859
)
 
(219.1
)%
Loss before income taxes
(3,038
)
 
(22,400
)
 
19,362

 
86.4
 %
Income tax (expense) benefit
(1,052
)
 
1,165

 
(2,217
)
 
(190.3
)%
Net loss
$
(4,090
)
 
$
(21,235
)
 
$
17,145

 
80.7
 %
Revenues

Gaming Operations. The increase in gaming operations revenue was primarily due to the increase in our EGM installed base of approximately 900 U.S. units, which is primarily attributable to the popularity of our new ICON and Orion cabinets and approximately 1,000 Mexico units, which is attributable to the to our gaining market share in under serviced markets within Mexico. We also had a 2.6%, or $0.64, increase in our U.S. EGM revenue per day through the optimization of our installed base by installing our newer and more competitive game content on our EGMs. Although the Company has experienced a decrease in participation share rates for gaming revenue received pursuant to participation agreements with Native American tribal customers, player demand, driven by the Company’s newer and more competitive game content, has offset the effects of decreased participation share rates and U.S. EGM revenue per day has increased in total.
    
Equipment Sales. The increase in equipment sales is due to the sale of 842 units in the three months ended September 30, 2017, compared to 66 units in the prior year period. The increase in the number of units sold is primarily attributable to the success of our new ICON and Orion cabinets and our growth in the Class III market in which many customers prefer to buy rather than lease EGMs. The increase was also attributable to a $1,529, or 10.6%, increase in the average sales price compared to the prior year period. The increase in equipment sales was offset by a decrease in revenues from the sale of nontransferable and nonexclusive licenses of certain licensed game content to a third party for $1.1 million in the prior year period that was not present in the current year period.

Operating Expenses

Cost of gaming operations. The increase in costs of gaming operations was the result of our increased installed base of 22,015 EGM units compared to 20,108 units in the prior year period, as well as increased table games installed base that increased 95.0% compared to the prior year period. As a percentage of gaming operations revenue, costs of gaming operations was 17.1% for the three months ended September 30, 2017 compared to 17.3% for the prior year period.


23


Cost of Equipment Sales. The increase in cost of equipment sales is attributable to the increase of 842 EGM units sold for the three months ended September 30, 2017 compared to 66 in prior year period.

Selling, general and administrative. The decrease in selling, general and administrative expenses is primarily due to the resolution in the prior year period of a $2.0 million customer liability related to the Cadillac Jack acquisition, $1.0 million in marketing costs due to the timing of tradeshows, $0.6 million decreased user acquisition fees from our Interactive segment in efforts to optimize marketing spend, $0.3 million decreased bad debt expense, and offset by increased salary and benefit costs of $0.9 million due to higher headcount.

Research and development. The decrease in research and development expenses is driven by decreased professional fees related to software testing and compliance of $1.0 million, which was offset by increases in salary and benefit costs of $0.7 million due to higher headcount. As a percentage of total revenue, research and development expense was 11.5% for the three months ended September 30, 2017 compared to 16.2% for the prior year period.

Write downs and other charges. During the three months ended September 30, 2017, the Company recognized $0.5 million in write-downs and other charges driven by losses from the disposal of assets.

During the three months ended September 30, 2016, the company recognized $1.9 million in write-downs and other charges, driven by a $3.3 million impairment of an intangible asset related to a customer contract that will provide less benefit than originally estimated from the Cadillac Jack acquisition (a level 3 fair value measurement based on a decrease in projected cash flows). The value of the intangible asset was written down to $1.1 million at an interim date and subsequently fully amortized by December 31, 2016. Additionally a write-down of long-lived assets of $1.3 million related to older generation gaming machines (level 3 fair value measurement based on projected cash flow for the specific assets) in which
the long-lived assets were written down to $0, and losses from the disposal of assets of $0.2 million. These charges were offset by a $3.0 million fair value adjustment to a contingent consideration receivable related to the Cadillac Jack acquisition.

Due to the changing nature of our write downs and other charges, we describe the composition of the balances as opposed to providing a year over year comparison.

Depreciation and amortization. The decrease was predominantly due to a $3.0 million decrease in amortization driven by certain intangible assets that have reached the end of their useful lives. Secondarily, the decrease was due to a $0.6 million decrease in depreciation driven by assets that have reached the end of their useful lives. These assets were fully depreciated at the beginning of the current period and therefore had no depreciation for three months ended September 30, 2017.

Other Expense (Income), net

Interest expense. The decrease in interest expense is predominantly attributed to the termination of our senior secured credit facilities and seller notes and entering into a first lien credit agreement on June 6, 2017. See Item 1. “Financial Statements” Note 6 for a detailed discussion regarding long-term debt.  These transactions resulted in a lower weighted average interest rate. These decreases were partially offset by an increase in the average principal amounts outstanding under the senior secured PIK notes of $15.0 million as of September 30, 2017, compared to the amount outstanding at September 30, 2016.

Other (income) expense. The decrease is predominantly attributed to effect of foreign currency fluctuation on trade payables and receivables denominated in foreign currencies. To a lesser extent, the change was due to a $0.2 million change in the balance of the tax indemnification receivable recorded in connection with the acquisition of Cadillac Jack.

Income Taxes

The Company's effective income tax rate for the three months ended September 30, 2017, was an expense of 34.6%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the three months ended September 30, 2017, was primarily due to changes in our valuation allowance on deferred tax assets. The Company's effective income tax rate for the three months ended September 30, 2016, was a benefit of 5.2%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the three months ended September 30, 2016, was primarily due to changes in our valuation allowance on deferred tax assets.
    

24


Nine Months Ended September 30, 2017 compared to the Nine Months Ended September 30, 2016

The following tables set forth certain selected condensed consolidated financial data for the nine months ended September 30, 2017 and 2016 (in thousands): 
 
Nine months ended September 30,
 
$
 
%
 
2017
 
2016
 
Change
 
Change
Consolidated Statements of Operations:
 
 
 
 
 
 
 
Revenues
 
 
 
 
 
 
 
Gaming operations
$
125,040

 
$
117,093

 
$
7,947

 
6.8
 %
Equipment sales
29,254

 
6,968

 
22,286

 
319.8
 %
Total revenues
154,294

 
124,061

 
30,233

 
24.4
 %
Operating expenses
 
 
 
 
 
 
 
Cost of gaming operations
21,794

 
19,627

 
2,167

 
11.0
 %
Cost of equipment sales
14,326

 
4,244

 
10,082

 
237.6
 %
Selling, general and administrative
30,368

 
36,654

 
(6,286
)
 
(17.1
)%
Research and development
17,912

 
16,517

 
1,395

 
8.4
 %
Write downs and other charges
2,655

 
2,153

 
502

 
23.3
 %
Depreciation and amortization
53,598

 
60,527

 
(6,929
)
 
(11.4
)%
Total operating expenses
140,653

 
139,722

 
931

 
0.7
 %
Income (loss) from operations
13,641

 
(15,661
)
 
29,302

 
187.1
 %
Other expense (income)
 
 
 
 
 
 
 
Interest expense
42,380

 
44,151

 
(1,771
)
 
(4.0
)%
Interest income
(80
)
 
(51
)
 
(29
)
 
(56.9
)%
Loss on extinguishment and modification of debt
8,129

 

 
8,129

 
 %
Other (income) expense
(4,805
)
 
6,314

 
(11,119
)
 
(176.1
)%
Loss before income taxes
(31,983
)
 
(66,075
)
 
34,092

 
51.6
 %
Income tax (expense) benefit
(4,603
)
 
4,935

 
(9,538
)
 
(193.3
)%
Net loss
$
(36,586
)
 
$
(61,140
)
 
$
24,554

 
40.2
 %
Revenues

Gaming Operations. The increase in gaming operations revenue was primarily due to the increase in our EGM installed base of approximately 900 U.S. units, which is primarily attributable to the popularity of our new ICON and Orion cabinets and approximately 1,000 Mexico units, which is attributable to the to our gaining market share in under serviced markets within Mexico. We also had a 2.1%, or $0.54, increase in our U.S. EGM revenue per day through the optimization of our installed base by installing our newer and more competitive game content on our EGMs. Although the Company has experienced a decrease in participation share rates for gaming revenue received pursuant to participation agreements with Native American tribal customers, player demand, driven by the Company’s newer and more competitive game content, has offset the effects of decreased participation share rates and U.S. EGM revenue per day has increased in total. Current period results have been negatively impacted by $1.0 million relating to foreign currency fluctuations compared to the prior year period. Additionally, we had a $0.2 million increase in Interactive revenue driven by Business-to-Consumer (“B2C”) arrangements when compared to the prior year period.

Equipment Sales. The increase in equipment sales is due to the sale of 1,868 units in the nine months ended September 30, 2017, compared to 205 units in the prior year period. The increase in the number of units sold is primarily attributable to the success of our new ICON and Orion cabinets and our growth in the Class III market in which many customers prefer to buy rather than lease EGMs. The increase was also attributable to a $1,205, or 8.2%, increase the average sales price compared to the prior year period. The increase in equipment sales was offset by a decrease in revenues from the sale of nontransferable and nonexclusive licenses of certain licensed game content to a third party for $3.2 million in the prior year period that was not present in the current year period.

Operating Expenses

Cost of gaming operations. The increase in costs of gaming operations was the result of our increased installed base of 22,015 EGM units compared to 20,108 units in the prior year period, as well as increased table games installed base that increased 95.0% compared to the prior year period. As a percentage of gaming operations revenue, costs of gaming operations was 17.4% for the nine months ended September 30, 2017 compared to 16.8% for the prior year period.

25



Cost of Equipment Sales. The increase in cost of equipment sales is attributable to the increase of 1,868 EGM units sold for the nine months ended September 30, 2017 compared to 205 in prior year period.

Selling, general and administrative. The decrease in selling, general and administrative expenses is primarily due to decreased user acquisition fees of $2.8 million from our Interactive segment in efforts to optimize marketing spend, the resolution in the prior year period of a $2.0 million customer liability related to the Cadillac Jack acquisition, $0.8 million in trade show and related marketing costs due to the timing of trade shows, and $0.8 million in legal and litigation expenses including settlement payments in the prior year period.

Research and development. The increase in research and development expenses is driven by increased salary and benefit costs of $2.3 million due to higher headcount and protype parts of $1.2 million associated with the development of our new Orion and Orion Slant cabinets, which are offset by decreased professional fees related to software testing and compliance of $2.1 million.  As a percentage of total revenue, research and development expense was 11.6% for the nine months ended September 30, 2017 compared to 13.3% for the prior year period.

Write downs and other charges. During the nine months ended September 30, 2017, the Company recognized $2.7 million in write-downs and other charges driven by losses from the disposal of assets of $3.0 million, the full impairment of certain intangible assets of $0.3 million (level 3 fair value measurement based on projected cash flows for the specific game titles), offset by a fair value adjustment to an acquisition contingent receivable of $0.6 million (level 3 fair value measurements based on projected cash flows). The contingency was resolved in the quarter ending March 31, 2017. See Item 1. “Financial Statements” Note 6 for a detailed discussion regarding the resolution of the contingency described above.

During the nine months ended September 30, 2016, the Company recognized $2.2 million in write-downs and other charges, driven by a $3.3 million impairment of an intangible asset related to a customer contract that will provide less benefit than originally estimated from the Cadillac Jack acquisition (a level 3 fair value measurement based on a decrease in projected cash flows). The value of the intangible asset was written down to $1.1 million at an interim date and subsequently fully amortized by December 31, 2016. Additionally, a write-down of long-lived assets of $1.3 million related to aged gaming machines, and losses from the disposal of assets of $0.6 million. These charges were offset by a $3.0 million fair value adjustment to a contingent consideration receivable related to the Cadillac Jack acquisition.

Due to the changing nature of our write downs and other charges, we describe the composition of the balances as opposed to providing a year over year comparison.

Depreciation and amortization. The decrease was predominantly due to a $5.8 million decrease in amortization driven by certain intangible assets that have reached the end of their useful lives. Secondarily, the decrease was due to a $1.2 million decrease in depreciation driven by assets that have reached the end of their useful lives. These assets were fully depreciated at the beginning of the current period and therefore had no depreciation for the nine months ended September 30, 2017.

Other Expense (Income), net

Interest expense. The decrease in interest expense is predominantly attributed to the termination of our senior secured credit facilities and seller notes and entering into a first lien credit agreement on June 6, 2017. See Item 1. “Financial Statements” Note 6 for a detailed discussion regarding long-term debt.  These transactions resulted in a lower weighted average interest rate. These decreases were partially offset by an increase in the average principal amounts outstanding under the senior secured PIK notes of $15.0 million as of September 30, 2017, compared to the amount outstanding at September 30, 2016.

Loss on extinguishment and modification of debt. The increase is attributed to the refinancing of the Company’s long-term debt, as described in Item 1. “Financial Statements” Note 6. Approximately $3.3 million of deferred loan costs and discounts related to our old senior secured credit facilities were written off as a portion of the loss on extinguishment and modification of debt and $4.8 million in debt issuance costs related to the first lien credit facilities were expensed.

Other (income) expense. The increase is predominantly attributed to effect of foreign currency fluctuation on trade payables and receivables denominated in foreign currencies. To a lesser extent, the change was due to a $4.8 million change in the balance of the tax indemnification receivable recorded in connection with the acquisition of Cadillac Jack.

Income Taxes


26


The Company's effective income tax rate for the nine months ended September 30, 2017, was an expense of 14.4%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2017, was primarily due to changes in our valuation allowance on deferred tax assets. The Company's effective income tax rate for the nine months ended September 30, 2016, was a benefit of 7.5%. The difference between the federal statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2016, was primarily due to an increase in our valuation allowance on deferred tax assets.

Segment Operating Results

We report our business segment results by segment in accordance with the “management approach.” The management approach designates the internal reporting used by our chief operating decision maker, who is our Chief Executive Officer, for making decisions and assessing performance of our reportable segments.

See Item 1. “Financial Statements” Note 1 for a detailed discussion of our three segments. Each segment’s activities include the design, development, acquisition, manufacturing, marketing, distribution, installation and servicing of its product lines. We evaluate the performance of our operating segments based on revenues and segment adjusted EBITDA.

Segment revenues include leasing, licensing or selling of products within each reportable segment. We measure segment performance in terms of revenue, segment-specific adjusted EBITDA and unit placements. We believe that unit placements are an important gauge of segment performance for EGM’s and Table Products because it measures historical market placements of leased and sold units and provides insight into potential markets for next-generation products and service. We do not present a cumulative installed base as previously sold units may no longer be in use by our customers or may have been replaced by other models or products. For our Interactive segment, we view the number of unique players and revenues provided by players on a daily or monthly basis.

27



The following tables provide reconciliations of segment financial information to our consolidated statement of operations. We have included revenues, operating expenses and other adjustments by segment which we believe are important to understanding the operating results of our segment:
 
Three months ended September 30, 2017
 
EGM
 
Table Products
 
Interactive
 
Total
Revenues
 
 
 
 
 
 
 
Gaming operations
$
39,767

 
$
1,072

 
$
2,010

 
$
42,849

Equipment sales
13,564

 
27

 

 
13,591

Total revenues
53,331

 
1,099

 
2,010

 
56,440

Cost of gaming operations(1)
6,352

 
405

 
587

 
7,344

Cost of equipment sales(1)
6,329

 
1

 

 
6,330

Selling, general and administrative
8,011

 
586

 
1,145

 
9,742

Research and development
5,537

 
524

 
406

 
6,467

Write downs and other charges
490

 

 

 
490

Depreciation and amortization
16,181

 
185

 
565

 
16,931

Total operating expenses
42,900

 
1,701

 
2,703

 
47,304

 

 
 
 
 
 
 
Write downs and other
 
 
 
 
 
 
 
Loss on disposal of long lived assets
490

 

 

 

Impairment of long lived assets

 

 

 

Fair value adjustments to contingent consideration and other items

 

 

 

Acquisition costs

 

 

 

Depreciation and amortization
16,181

 
185

 
565

 

Accretion of placement fees(2)
1,192

 

 

 

Acquisitions & integration related costs including restructuring & severance(3)
65

 
5

 
1

 

Legal & litigation expenses including settlement payments(4)
181

 

 

 

New jurisdictions and regulatory licensing costs(5)
556

 
11

 

 

Non-cash charge on capitalized installation and delivery(6)
359

 

 

 

Non-cash charges and loss on disposition of assets(7)

 

 

 

Other adjustments(8)
301

 
169

 
4

 

Adjusted EBITDA
$
29,756

 
$
(232
)
 
$
(123
)
 


(1) Exclusive of depreciation and amortization.
(2) Non-cash item related to the accretion of contract rights under development agreements and placement fees.
(3) Acquisitions & integration related costs primarily relate to costs incurred after the purchase of businesses, such as the purchase of Cadillac Jack and AGSi, to integrate operations and obtain costs synergies. Restructuring and severance costs primarily relate to costs incurred through the restructuring of the Company’s operations from time to time and other employee severance costs recognized in the periods presented.
(4) Legal and litigation related costs consist of payments to law firms and settlements for matters that are outside the normal course of business. These costs
related to litigation and matters that were not significant individually.
(5) New jurisdictions and regulatory licensing costs primarily relate to the costs the Company incurred to obtain licenses and develop products for new jurisdictions.
(6) Non-cash charge on capitalized installation and delivery primarily include the costs to acquire contracts that are expensed over the estimated life of each contract.
(7) Non-cash charges and loss on disposition of assets are primarily composed of the net book value of electronic gaming machines sold into secondary markets. These gaming machines were previously leased to customers and sold at substantially lower average selling prices. Additional non-cash inventory obsolescence charges are also included.
(8) Other adjustments are primarily composed of professional fees incurred by the Company for projects, corporate and public filing compliance, contract cancellation fees, and other costs deemed to be non-recurring in nature.


28



 
Three months ended September 30, 2016
 
EGM
 
Table Products
 
Interactive
 
Total
Revenues
 
 
 
 
 
 
 
Gaming operations
$
36,048

 
$
672

 
$
2,157

 
$
38,877

Equipment sales
2,329

 
2

 

 
2,331

Total revenues
38,377

 
674

 
2,157

 
41,208

Cost of gaming operations(1)
5,749

 
350

 
612

 
6,711

Cost of equipment sales(1)
698

 

 

 
698

Selling, general and administrative
10,600

 
643

 
1,727

 
12,970

Research and development
5,761

 
489

 
425

 
6,675

Write downs and other charges
1,852

 

 

 
1,852

Depreciation and amortization
18,806

 
404

 
209

 
19,419

Total operating expenses
43,466

 
1,886

 
2,973

 
48,325

 
 
 
 
 
 
 
 
Write downs and other
 
 
 
 
 
 
 
Loss on disposal of long lived assets
248

 

 

 
 
Impairment of long lived assets
4,604

 

 

 
 
Fair value adjustments to contingent consideration and other items
(3,000
)
 

 

 
 
Acquisition costs

 

 

 
 
Depreciation and amortization
18,806

 
404

 
209

 
 
Accretion of placement fees(2)
1,190

 

 

 
 
Acquisitions & integration related costs including restructuring & severance(3)
2,413

 
272

 

 
 
Legal & litigation expenses including settlement payments(4)
235

 
126

 

 
 
New jurisdictions and regulatory licensing costs(5)
812

 
30

 

 
 
Non-cash charge on capitalized installation and delivery(6)
353

 

 

 
 
Non-cash charges and loss on disposition of assets(7)
285

 

 

 
 
Other adjustments(8)
86

 

 

 
 
Adjusted EBITDA
$
20,943

 
$
(380
)
 
$
(607
)
 
 

(1) Exclusive of depreciation and amortization.
(2) Non-cash item related to the accretion of contract rights under development agreements and placement fees.
(3) Acquisitions & integration related costs primarily relate to costs incurred after the purchase of businesses, such as the purchase of Cadillac Jack and AGSi, to integrate operations and obtain costs synergies. Restructuring and severance costs primarily relate to costs incurred through the restructuring of the Company’s operations from time to time and other employee severance costs recognized in the periods presented.
(4) Legal and litigation related costs consist of payments to law firms and settlements for matters that are outside the normal course of business. These costs
related to litigation and matters that were not significant individually.
(5) New jurisdictions and regulatory licensing costs primarily relate to the costs the Company incurred to obtain licenses and develop products for new jurisdictions.
(6) Non-cash charge on capitalized installation and delivery primarily include the costs to acquire contracts that are expensed over the estimated life of each contract.
(7) Non-cash charges and loss on disposition of assets are primarily composed of the net book value of electronic gaming machines sold into secondary markets. These gaming machines were previously leased to customers and sold at substantially lower average selling prices. Additional non-cash inventory obsolescence charges are also included.
(8) Other adjustments are primarily composed of professional fees incurred by the Company for projects, corporate and public filing compliance, contract cancellation fees, and other costs deemed to be non-recurring in nature.






29


 
Nine months ended September 30, 2017
 
EGM
 
Table Products
 
Interactive
 
Total
Revenues
 
 
 
 
 
 
 
Gaming operations
$
116,587

 
$
2,348

 
$
6,105

 
$
125,040

Equipment sales
29,160

 
94

 

 
29,254

Total revenues
145,747

 
2,442

 
6,105

 
154,294

Cost of gaming operations(1)
19,188

 
798

 
1,808

 
21,794

Cost of equipment sales(1)
14,318

 
8

 

 
14,326

Selling, general and administrative
25,490

 
1,424

 
3,454

 
30,368

Research and development
15,652

 
1,277

 
983

 
17,912

Write downs and other charges
2,655

 

 

 
2,655

Depreciation and amortization
51,603

 
1,012

 
983

 
53,598

Total operating expenses
128,906

 
4,519

 
7,228

 
140,653

 
 
 
 
 
 
 
 
Write downs and other
 
 
 
 
 
 
 
Loss on disposal of long lived assets
3,000

 

 

 

Impairment of long lived assets
285

 

 

 

Fair value adjustments to contingent consideration and other items
(630
)
 

 

 

Acquisition costs

 

 

 

Depreciation and amortization
51,603

 
1,012

 
983

 

Accretion of placement fees(2)
3,492

 

 

 

Acquisitions & integration related costs including restructuring & severance(3)
952

 
164

 
(217
)
 

Legal & litigation expenses including settlement payments(4)
766

 

 

 

New jurisdictions and regulatory licensing costs(5)
1,293

 
11

 

 

Non-cash charge on capitalized installation and delivery(6)
1,284

 

 

 

Non-cash charges and loss on disposition of assets(7)
686

 

 

 

Other adjustments(8)
1,878

 
169

 
20

 

Adjusted EBITDA
$
81,450

 
$
(721
)
 
$
(337
)
 


(1) Exclusive of depreciation and amortization.
(2) Non-cash item related to the accretion of contract rights under development agreements and placement fees.
(3) Acquisitions & integration related costs primarily relate to costs incurred after the purchase of businesses, such as the purchase of Cadillac Jack and AGSi, to integrate operations and obtain costs synergies. Restructuring and severance costs primarily relate to costs incurred through the restructuring of the Company’s operations from time to time and other employee severance costs recognized in the periods presented.
(4) Legal and litigation related costs consist of payments to law firms and settlements for matters that are outside the normal course of business. These costs
related to litigation and matters that were not significant individually.
(5) New jurisdictions and regulatory licensing costs primarily relate to the costs the Company incurred to obtain licenses and develop products for new jurisdictions.
(6) Non-cash charge on capitalized installation and delivery primarily include the costs to acquire contracts that are expensed over the estimated life of each contract.
(7) Non-cash charges and loss on disposition of assets are primarily composed of the net book value of electronic gaming machines sold into secondary markets. These gaming machines were previously leased to customers and sold at substantially lower average selling prices. Additional non-cash inventory obsolescence charges are also included.
(8) Other adjustments are primarily composed of professional fees incurred by the Company for projects, corporate and public filing compliance, contract cancellation fees, and other costs deemed to be non-recurring in nature.



30


 
Nine months ended September 30, 2016
 
EGM
 
Table Products
 
Interactive
 
Total
Revenues
 
 
 
 
 
 
 
Gaming operations