SHFL Shfl Entertainment, Inc. (MM)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

1. DESCRIPTION OF BUSINESS AND INTERIM BASIS OF PRESENTATION

Description of business.   Unless the context indicates otherwise, references to “SHFL entertainment, Inc.,” “we,” “us,” “our,” or the “Company,” include SHFL entertainment, Inc. and its consolidated subsidiaries.

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

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

Utility .  Our Utility segment develops products for licensed casino operators that enhance table game speed, productivity, profitability and security. Utility products include various models of automatic card shufflers to suit specific games, as well as deck checkers and roulette chip sorters. This segment also includes our i-Shoe Auto card reading shoe that gathers data and enables casinos to track table game play and our i-Score baccarat viewer that displays current game results and trends. These products are intended to cost-effectively provide licensed casino operators and other users with data on table game play for security and marketing purposes, which in turn allows them to increase their profitability.

Proprietary Table Games.  Our PTG segment consists of proprietary table games that enhance our casino customers' and other licensed operators' table game operations. Products in this segment include our internally developed and acquired proprietary table games, side bets, add-ons and progressives.  Our proprietary content and features are also added to public domain games such as poker, baccarat, pai gow poker, craps and blackjack table games and to electronic platforms such as Table Master , SHFL FUSION Virtual (formerly Vegas Star ) and i-Table .

Electronic Table Systems.   Our ETS segment consists of various products involving popular table game content using e-Table game platforms. Our primary ETS products are i-Table , Table Master , SHFL FUSION Virtual and SHFL FUSION Hybrid Table Games (formerly Rapid Table Games) .  Our i-Table platform combines an electronic betting interface with a live dealer and live cards or a live wheel that is designed to improve game speed and security while reducing many operating expenses associated with live tables.  Our Table Master and SHFL FUSION Virtual products feature a virtual dealer which enables us to offer table game content in both traditional gaming markets and in markets where live table games are not permitted, such as some racinos, video lottery and arcade markets. Like the i-Table , our SHFL FUSION Hybrid Table Games product enables the automation of certain components of traditional table games such as data collection, placement of bets, collection of losing bets and payment of winning bets combined with live dealer and game outcomes. This automation provides benefits to both casino operators and players, including greater security and faster speed of play.  Unlike the i-Table , SHFL FUSION Hybrid Table Games is not confined to a fixed number of seats and can have hundreds of terminals tied to one game outcome.

Electronic Gaming Machines .   Our EGM segment develops and delivers our video slot machines into markets including Australia, New Zealand, Asia, Mexico, parts of South America, and most recently, select markets in the United States.  We offer a selection of video slot titles developed as stand-alone units or as linked progressive machines. In addition to selling the full EGM complement, we sell software conversion kits that allow existing EGM terminals to be converted to other games that operate on the current PC4 operating platform. Popular titles for our EGMs include Cats Hats & Bats , Eureka Gold Mine 2 , 88 Fortunes , Emerald Fortunes and Mahajanga .  In addition, we continue to develop a popular range of games utilizing the Pink Panther™ brand, under license from Metro-Goldwyn-Mayer Studios, Inc.  We also develop games incorporating features and bonus rounds based on the popular 1960’s animated television series, The Flintstones ^TM & © Hanna-Barbera s13.

iGaming.   Our iGaming segment delivers online versions of our specialty table games via our proprietary content delivery platform to online operators.  Utilizing cloud-based technology, our platform is designed to deliver our games across multiple channels such as the web, social networks, tablets and smart phones both in free-to-play environments and for real money gambling in regulated online markets.  We also license our content to online operators and protect the integrity of our valuable brands by pursuing online operators that infringe upon our intellectual property.  Our iGaming segment primarily offers products to our customers through business-to-business (“B2B”) lease, license and participation arrangements.  We are continuing to invest in this segment – namely, by expanding our team – to capitalize on the various existing and potential online markets.

Basis of presentation.   The accompanying Unaudited Condensed Consolidated Financial Statements include the results of operations, financial position and cash flows of SHFL entertainment, Inc. and its consolidated subsidiaries. All material intercompany balances have been eliminated.  

In the opinion of our management, the accompanying Unaudited Condensed Consolidated Financial Statements include all adjustments necessary to fairly state, in all material respects, our results for the periods presented. These Condensed Consolidated Financial Statements have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with Generally Accepted Accounting Principles (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations.  These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and accompanying notes included in our 2012 Annual Report on Form 10-K filed with the SEC on December 21, 2012.  The results of operations for the three and nine months ended July 31, 2013 are not necessarily indicative of results to be expected for the entire fiscal year.

Use of estimates and assumptions. The preparation of our consolidated financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.  Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our consolidated financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. We evaluate and update our assumptions and estimates on an ongoing basis. Actual results could differ from those estimates.

Revenue recognition. We recognize revenues when all of the following have been satisfied:

Revenues are reported net of incentive rebates and discounts. Amounts billed prior to completing the earnings process are deferred until revenue recognition criteria are met. Our standard sales contracts do not contain right of return provisions and we have not experienced significant sales returns.  Therefore we have not recorded an allowance for sales returns.

Product lease and royalty revenue — Lease and royalty revenue is earned from the leasing of our tangible products and the licensing of our intangible products, such as our proprietary table games. When we lease or license our products, we generally negotiate month-to-month fixed fee contracts, or to a lesser extent, enter into participation arrangements whereby casinos pay a fee to us based on a percentage of net win.   Lease and royalty revenue commences upon the completed installation of the product. Lease terms are generally cancellable with 30 days’ notice.  We recognize revenue from our leases and licenses upon installation of our product on a month-to-month basis.

Product sales and service revenue — We generate sales revenue through the sale of equipment in each product segment, including sales revenue from sales-type leases and the sale of lifetime licenses for our proprietary table games. Our credit sales terms are primarily 30 to 90 days.  Financing for intangible property and sales-type leases for tangible property have payment terms ranging generally from 24 to 36 months and are usually interest-bearing at market interest rates. Revenue from the sale of equipment is recorded in accordance with the contractual shipping terms. Products placed with customers on a trial basis are not recognized as revenue until the trial period ends, the customer accepts the product and all other relevant criteria have been met. If a customer purchases existing leased equipment, revenue is recorded on the effective date of the purchase agreement. Revenue on service and warranty contracts is recognized as the services are provided over the term of the contracts. Revenue from the sale of lifetime licenses or settlements with online operators, under which we have no continuing obligation, is recorded on the effective date of the license or settlement agreement.

Multiple element arrangements — Some of our revenue arrangements contain multiple deliverables, such as a product sale combined with a service element or the delivery of a future product.  We allocate revenues among multiple deliverables in a multi-element arrangement, based on relative selling prices. In order of preference, relative selling prices will be estimated based on vendor specific objective evidence (“VSOE”), third-party evidence (“TPE”), or management’s best estimate of selling price (“BESP”).

When VSOE or TPE is not available, BESP is the amount we would sell the product or service for individually. The determination of BESP is made based on our normal pricing and discounting practices, which consider multiple factors, such as market conditions, competitive landscape, internal costs and profit objectives.  Revenues allocated to future performance obligations elements are deferred and will be recognized upon delivery and customer acceptance.

Recently issued accounting standards or updates – adopted

In the current year, we adopted an Accounting Standards Update (“ASU”) which requires other comprehensive income to be presented with net income in one continuous statement or in a separate statement consecutively following net income. We adopted the ASU as of November 1, 2012 and chose to present comprehensive income in a separate Condensed Consolidated Statement of Comprehensive Income.

Recently issued accounting standards or updates – not adopted

In March 2013, the FASB issued an ASU requiring the release of cumulative translation adjustment into net income when an entity either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a foreign subsidiary. This ASU will be effective prospectively for our 2015 first quarter and is not expected to have a material impact on our financial statements.

Proposed Merger with Bally Technologies, Inc.

On July 15, 2013, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) by and among the Company, Bally Technologies, Inc., a Nevada corporation ("Bally"), and Manhattan Merger Corp., a Minnesota corporation and an indirect, wholly-owned subsidiary of Bally (“Merger Sub”). The Merger Agreement provides for the merger of Merger Sub with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Bally. The Merger Agreement was unanimously approved by our board of directors and a committee of disinterested directors of our board of directors.

At the effective time of the proposed Merger, on the terms and subject to the conditions set forth in the Merger Agreement, each share of SHFL’s common stock, par value $0.01 (“SHFL Common Stock”) issued and outstanding immediately prior to such time, other than shares of SHFL Common Stock owned by SHFL, Bally or Merger Sub (each of which will be cancelled) and shares of SHFL Common Stock with respect to which appraisal rights are properly exercised and not withdrawn under Minnesota law, shall be automatically cancelled and converted into the right to receive $23.25 in cash, without interest. If the proposed Merger is consummated, shares of SHFL Common Stock will be delisted from the NASDAQ. No assurance can be given that the Merger will be completed.

Consummation of the proposed Merger is subject to customary conditions, including without limitation (i) the required approval of the Merger Agreement by SHFL’s shareholders, (ii) the expiration or early termination of the waiting period applicable to the consummation of the proposed Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1974, as amended (the “HSR Act”) (which waiting period, as previously announced, expired as of 11:59 p.m. EDT on August 26, 2013 with no action by the Federal Trade Commission or the Department of Justice), (iii) the receipt of specified licenses, permits, and other approvals relating to SHFL’s gaming operations issued by certain governmental authorities, (iv) the absence of any law or order that is in effect and restrains, enjoins or otherwise prohibits the proposed Merger, (v) the accuracy of the representations and warranties of the parties and compliance by the parties with their respective obligations under the Merger Agreement (subject to customary materiality qualifiers) and (vi) the absence of any change, effect, development or circumstance that, individually or in the aggregate, constitutes or is reasonably likely to constitute a Company Material Adverse Effect (as defined in the Merger Agreement).

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

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

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

During the nine months ended July 31, 2013, we incurred approximately $4.0 million of expenses related to the Merger Agreement. These expenses consisted primarily of payments to financial advisors and consultation with legal counsel.

In the first quarter of the current year, we made a change in our accounting estimates relating to the depreciable lives of the Table Master leased and available for lease machines in the ETS segment. In anticipation of the launch of Table Master Fusion we shortened the estimated economic life of the leased and available for lease machines to be fully depreciated by April 2014.

The net effect of the change on book income from operations and net income for the three and nine months ended July 31, 2013 was $0.3 million and $0.8 million, respectively. There was no net effect on EPS for the three months ended July 31, 2013 and there was a $0.01 effect for the nine months ended July 31, 2013.

3. INTANGIBLE ASSETS AND GOODWILL

Amortizable intangible assets.   All of our recorded intangible assets, excluding goodwill and the Stargames and CARD tradenames, are subject to amortization. We amortize our intangible assets as the economic benefits of the intangible asset are consumed or otherwise used up.  Amortization expense was $2.0 million and $2.2 million for the three months ended July 31, 2013 and 2012, respectively and $6.2 million and $6.8 million for the nine months ended July 31, 2013 and 2012, respectively. Amortization expenses are included in cost of leases and royalties and cost of sales and service, except for customer relationships which are included in selling, general and administrative expenses.

Amortizable intangible assets are comprised of the following:

Tradenames. Intangibles with an indefinite life, consisting of the Stargames and CARD tradenames, are not amortized, and were $21.9 million and $24.5 million as of July 31, 2013 and October 31, 2012, respectively.

Goodwill.   Changes in the carrying amount of goodwill as of July 31, 2013, are as follows:

The $2.7 million of additional goodwill in our EGM segment relates to the acquisition of ProTec Games, Inc. ("ProTec"), a computer-based content provider for casino slot games, table games and online video games to develop graphical assets and perform software development and testing primarily for our EGM machines. Approximately $2.1 million of the acquisition price was paid to date and the remaining consideration was recorded as a liability due in the current fiscal fourth quarter.

The $0.5 million of additional goodwill in our PTG segment relates to our acquisition of certain assets from Bet Technology, Inc. (“BTI”) in 2004.  In 2004, we recorded an initial estimated liability of $7.6 million for contingent installment payments computed as the excess fair value of the acquired assets over the fixed installments and other direct costs.  In November 2004, we began paying monthly note installments based on a percentage of certain revenue from BTI games for a period of up to ten years, not to exceed $12.0 million. The final principal and interest payment related to our initial estimated liability of $7.6 million was paid in February 2009 and all payments made subsequently have been recorded as additional goodwill. As of July 31, 2013, we have paid the $12.0 million maximum amount.

$200.0 million senior secured revolving credit facility. On October 29, 2010, we entered into a senior secured credit agreement (the “Senior Secured Revolving Credit Facility”) with Wells Fargo Securities, LLC and Banc of America Securities LLC as joint lead arrangers and joint lead bookrunners, Bank of America, N.A. as syndication agent and Union Bank, N.A. as documentation agent. The Senior Secured Revolving Credit Facility provides for senior secured credit facilities in an aggregate principal amount of $200.0 million consisting of a 5-year revolving credit facility (the “Revolver”) in an aggregate principal amount of $200.0 million with a sub-facility for letters of credit of $25.0 million, a sub-facility for multicurrency borrowings in Euros, Australian dollars and Canadian dollars of $25.0 million, and a sub-facility for swing line loans of $20.0 million, each on customary terms and conditions. The Senior Secured Revolving Credit Facility includes an option to increase the Revolver to $300.0 million, which would require syndication approval.

Loans under the Revolver (other than Swing Line Loans, as defined) bear interest based on the Base Rate, as defined, or LIBOR, as elected by us. Base Rate interest is calculated at the Base Rate plus the applicable margin and the Base Rate is the highest of:

Swing Line Loans bear interest at the Base Rate plus the applicable margin. Borrowings under the Revolver may be used for working capital, capital expenditures and general corporate purposes (including share repurchases).

As of July 31, 2013, there was no amount drawn under the Revolver and after considering restrictive financial covenants under the Senior Secured Revolving Credit Facility, we had approximately $200 million of available remaining credit under the Revolver. The Revolver matures on, and no further borrowings may be made after, October 29, 2015.

On May 31, 2012, the Senior Secured Revolving Credit Facility was amended to clarify and define certain restrictive covenants.

Covenants. Our Senior Secured Revolving Credit Facility contains three financial maintenance covenants requiring us to maintain a Total Leverage Ratio, as defined therein, of not more than 3.75 to 1.0, a Senior Leverage Ratio, as defined therein, of not more than 3.0 to 1.0 until October 31, 2013 and not more than 2.75 to 1.00 after October 31, 2013 and Interest Expense Coverage Ratio, as defined therein, in excess of 3.0 to 1.0 at the end of any fiscal quarter. As of July 31, 2013, our Total Leverage Ratio, Senior Leverage Ratio and Interest Expense Coverage Ratio were 0.02 to 1.0, 0.0 to 1.0 and 141.11 to 1.0, respectively.

Guarantors and collateral .  The Revolver obligations under our Senior Secured Revolving Credit Facility are guaranteed by each existing and future wholly-owned domestic subsidiary of ours that is not an immaterial subsidiary and are secured by a first priority lien on substantially all of our and our guarantors’ assets.  If loans are ever made pursuant to our Incremental Facility, such loans would share such collateral equally and ratably with our Revolver.

5. SHAREHOLDERS’ EQUITY

Common stock repurchases. Our board of directors periodically authorizes us to repurchase shares of our common stock.  As of July 31, 2013, $21.1 million remained outstanding under our board authorization; however, pursuant to the Merger Agreement with Bally, stock repurchases are prohibited until the proposed Merger is effective or terminated.  We cancel shares that are repurchased and record the repurchase as a reduction to common stock and additional paid-in capital.  No shares were repurchased during the nine months ended July 31, 2013. Although we generally prioritize bank debt reduction and direct investment in our business over share repurchases we may consider share repurchases when there are anomalies in the value created by, but not limited to, market conditions.

The timing of our common stock repurchases pursuant to our board of directors’ authorization is dependent on future opportunities and on our views, as they may change from time to time, as to the most prudent uses of our capital resources, including cash and borrowing capacity.

6. SHARE-BASED COMPENSATION

Share-based award plans.   In December 2012, our board of directors adopted and, in March 2013, our shareholders approved the 2012 Stock Incentive Plan (the “2012 Plan”). The approved plan replaced all previous plans.  The 2012 Plan included 6.7 million new awards available for grant as well as the shares available for grant or subject to outstanding awards under the prior plans.

The 2012 Plan includes a variety of forms of awards, including stock options, stock appreciation rights, restricted stock, restricted stock units and dividend equivalents.  Stock options may not be granted at an exercise price less than the market value of our common stock on the date of grant.  Each share issued in connection with an award granted, other than stock options and stock appreciation rights, will be counted against the 2012 Plan's share reserve as 1.67 shares for every one share issued in connection with such award (and shall be counted as 1.67 shares for each one share that is returned or deemed not to have been issued from the 2012 Plan). Any shares covered by an award which is forfeited, canceled or expired shall be deemed not to have been issued for purposes of determining the maximum number of shares which may be issued under the 2012 Plan. As of July 31, 2013, under the 2012 Plan, there were 7.4 million shares available for grant.  

A summary of activity related to stock options is presented below:

The weighted average grant date fair value of stock options granted during the nine months ended July 31, 2013 and 2012 was $6.56 and $6.26, respectively. The total intrinsic value of the stock options exercised for the nine months ended July 31, 2013 and 2012, was $3.8 million and $6.2 million, respectively.

During the nine months ended July 31, 2013 and 2012, 0.5 million and 1.5 million options were exercised, respectively. For the nine months ended July 31, 2013 and 2012, the tax effect/benefit from stock option exercises affected our deferred tax asset or income tax payable as well as our additional paid-in capital by an equal amount and had no effect on our income tax provision. As of July 31, 2013, there was a total of $5.4 million of unamortized compensation related to stock options, which expense is expected to be recognized over a weighted-average period of 1.8 years or immediately upon a change in control as defined in the 2012 Plan.
 

During the nine months ended July 31, 2013 and 2012, we granted 0.5 million and 0.4 million stock options, respectively, with a grant date fair value of $3.5 million and $2.8 million, respectively.

Option valuation models require the input of certain assumptions and changes in assumptions used can materially affect the fair value estimate. Expected volatility is based on the historical volatility of our common stock. Expected term represents the estimated weighted-average time between grant date and its exercise date and is based on historical factors. Expected dividend yield is based on our expectation that dividends will not be paid within the average expected life of existing options. Risk-free interest rate is based on U.S. Treasury rates appropriate for the expected term. There were no stock awards during the three months ended July 31, 2013. We estimate the fair value of each stock option award on the grant date using the Black-Scholes valuation model incorporating the weighted-average assumptions noted in the following table:

A summary of activity related to restricted stock is presented below:

During the nine months ended July 31, 2013 and 2012, we issued 0.4 million and 0.5 million shares of restricted stock, respectively, with an aggregate fair value of $6.2 million and $5.6 million, respectively. The weighted average grant date fair value of non-vested shares granted during the nine months ended July 31, 2013 and 2012 was $14.88 and $12.35, respectively. The total value of each restricted stock grant, based on the fair market value of the stock on the date of grant, is amortized to compensation expense over the related vesting period.

In the current year certain restricted stock awards containing market-based conditions were issued. The market-based conditions affect the number of shares to vest, which varies based on the Company’s stock price compared to several peers and competitors. For restricted stock subject to market-based conditions, the Company uses a Monte-Carlo simulation pricing model to determine the grant date fair value. The Monte-Carlo simulation pricing model takes into account the same input assumptions as the Black-Scholes model; however, it also further incorporates into the fair value determination the possibility that the market condition may not be satisfied and impact of the possible differing stock price paths. There were no restricted stock awards with market conditions granted during the three months ended July 31, 2013. The following assumptions were used in the Monte-Carlo pricing model:

As of July 31, 2013, there was $8.8 million of unamortized compensation expense related to restricted stock, which is expected to be recognized over a weighted-average period of 1.8 years or immediately upon a change in control as defined in the 2012 Plan.

Recognition of compensation expense.   The following table shows information about compensation costs recognized:

7. INCOME TAXES

Our effective income tax rate from continuing operations for the three and nine months ended July 31, 2013 was 25.8% and 28.6%, respectively. Our effective income tax rate from continuing operations for the three and nine months ended July 31, 2012 was 21.8% and 28.1%, respectively. The higher effective income tax rate is primarily attributable to non-deductible expenses recorded in the current period for transaction costs related to the proposed Merger as well as the mix of forecasted domestic and foreign income for the year. The prior year included a benefit in the quarter ended July 31, 2012 for transaction costs related to the terminated acquisition of Ongame Network Ltd, which became deductible in the quarter. Our effective income tax rate may fluctuate due to changes in the amount and mix of domestic and foreign income, changes in tax legislation, changes in valuation allowances and changes in assessments of uncertain tax positions and related accumulated interest and penalties.

9. FAIR VALUE MEASUREMENT

We utilize a three level hierarchy that defines the assumptions used to measure certain assets and liabilities at fair value.

Cash and cash equivalents, accounts receivable, the current portion of our investment in sales-type leases and notes receivable are not presented as their carrying value approximates fair value due to their short term nature.  It is impracticable to estimate the fair value of the long-term portion of our investment in sales-type leases and notes receivable as it is comprised of many insignificant balances, customers with different credit profiles and various interest rates.  As of July 31, 2013 our investment in sales-type leases and notes receivable had an approximate 5.5% effective interest rate and an approximate 2 year average maturity.

As of July 31, 2013 and October 31, 2012, there were no amounts drawn under our Revolver.

10. OPERATING SEGMENTS

The iGaming segment results have historically not met the quantitative thresholds that require separate segment reporting and therefore that segment was aggregated with the PTG and Unallocated Corporate segment results in the prior year. In the current year iGaming has been separately reported and the prior period segment data has been restated to conform to the current period presentation. Also in the current period the Unallocated Corporate capital expenditures consist primarily of amounts paid for the construction of our new consolidated facility in Las Vegas. The following provides financial information concerning our reportable segments of our operations:

11. COMMITMENTS AND CONTINGENCIES

Employment agreements.  We have entered into employment agreements with our corporate officers and certain other key employees with durations ranging from one to three years. Significant contract provisions include minimum annual base salaries, healthcare benefits, bonus compensation if performance measures are achieved and non-compete provisions. These contracts are primarily “at will” employment agreements, under which the employee or we may terminate employment. If we terminate any of these employees without cause, we are obligated to pay the employee payments as specified in their individual employment agreement. As of July 31, 2013 and October 31, 2012, minimum aggregate severance benefits totaled $6.7 million and $6.5 million, respectively.

Contingencies relating to the Proposed Merger – The Company retained Macquarie Capital (USA) Inc. to act as its financial advisor in connection with the proposed Merger. The financial advisor will receive a transaction fee currently expected to be $13.6 million for its services, $2.0 million of which became payable upon the rendering of the financial advisor’s opinion and the principal portion of which is contingent upon completion of the proposed Merger. In addition, the Company has agreed to reimburse the financial advisor for expenses incurred in connection with its engagement.

Legal proceedings . In the ordinary course of business, we are involved in various legal proceedings and other matters that are complex in nature and have outcomes that are difficult to predict.  We record accruals for such contingencies to the extent that we conclude that it is probable that a loss will be incurred and the amount of loss can be reasonably estimated.  No estimate of the reasonably possible loss or range of loss in excess of amounts accrued, if any, can be made at this time regarding the matters specifically described below because the inherently unpredictable nature of legal proceedings may be affected by various factors, including: (i) the damages sought in the proceedings are unsubstantiated or indeterminate; (ii) discovery or other material legal proceedings are incomplete; (iii) the proceeding is in its early stages and there is insufficient information available to assess the viability of the stated grounds; (iv) the matters present legal uncertainties; (v) there are significant facts in dispute; or (vi) the trier of fact is granted latitude by applicable law to apply judgment.  Our assessment of each matter may change based on future unexpected events.  An unexpected adverse judgment in any pending litigation could cause a material impact on our business operations, gaming licenses, intellectual property, results of operations or financial position.  Unless otherwise expressly stated, we believe costs associated with litigation will not have a material impact on our financial position or liquidity, but may be material to the results of operations in any given period.  We assume no obligation to update the status of pending litigation after the date of this Quarterly Report on Form 10-Q, except as may be required by applicable law, statute or regulation.

TableMAX – In April 2009, TableMAX IP Holdings, Inc. and TableMAX Gaming, Inc. filed a complaint (the “First Complaint”) against us in the United States District Court for the District of Nevada.  This case is a patent infringement claim alleging that our Table Master  product infringes U.S. Patents 5,688,174, 6,921,337 and 7,201,661.  The First Complaint sought injunctive relief and an unspecified amount of damages, including claims for attorneys’ fees, costs, increased damages and disbursements.  In August 2009, TableMAX Holdings, Inc. and TableMAX Gaming, Inc. voluntarily dismissed the First Complaint.  On the same date, TableMAX IP Holdings, Inc., TableMAX Gaming, Inc. and Vegas Amusement, Inc. (the alleged owner of Patents 5,688,174, 6,921,337 and 7,201,661) (collectively “TableMAX”), filed a new complaint (the “New Complaint”) making materially the same allegations as in the First Complaint.  In August 2009, TableMAX filed an amended complaint (the “Second Complaint”), which was materially the same as the New Complaint, except that the plaintiffs added a claim that Table Master  infringes U.S. Patent 7,575,512, which was issued on August 18, 2009.  In August 2009, the plaintiffs filed a Motion for Preliminary Injunction in the Second Complaint that sought to enjoin future sales of Table Master .  In October 2009, the Court denied the Motion for Preliminary Injunction without hearing oral argument and also denied without prejudice our motions for summary judgment. During the discovery process, TableMAX made new allegations that certain of our  SHFL FUSION Virtual (formerly Vegas Star) products infringe one of the patents in the Second Complaint. In January 2010, TableMAX filed a Second Amended Complaint, which has materially the same allegations as the Second Complaint, except that it alleges that the SHFL FUSION Virtual product infringes all of the patents in suit.  However, a document produced in the discovery process appears to limit TableMAX's allegations of infringement regarding certain of our SHFL FUSION  Virtual products to only one of TableMAX's patents in suit. 

The Court set the Markman hearing for December 2010.  In November 2010, the Court granted our Motion to Stay because of pending reexamination proceedings that were initiated at our request before the United States Patent and Trademark Office (“USPTO”) as to all of the patents in suit.  In June 2012, the USPTO granted our petitions to reexamine two of the patents in suit, which patents were previously granted a Reexamination Certificate.   At present, the case remains stayed.  The Company believes that it has meritorious defenses and intends to continue to vigorously defend this matter.

Macau  SHFL FUSION Hybrid Table Games Patent Issue – In June 2009, customs officials from Macau SAR seized a baccarat SHFL FUSION Hybrid Table Games (formerly Rapid Table Games) unit displayed by SHFL entertainment (Asia) Limited (“SHFL Asia”) at the G2E Asia Gaming Show.  This seizure related to a claim by Jay Chun (“Chun”) of alleged patent infringement.  In October 2009, the Office of the Public Prosecutor dismissed the investigation after a series of appeals and procedural developments.  Chun appealed to the Investigation Judge, which proceedings were dismissed. From this decision, Chun appealed to the Macau Second Instance Court, which remanded the matter to the Investigation Court “Tribunal de Instrução Criminal” for further proceedings.   In January 2013, the Investigation Court formally served an accusation on SHFL Asia.  A Trial Hearing of this matter began on April 18, 2013 and was concluded on July 19, 2013 with the acquittal of SHFL Asia. The Court’s acquittal found no patent infringement by SHFL Asia. On July 29, 2013, Chun appealed the acquittal to the Macau Second Instance Court. We believe that we have meritorious defenses and will continue to vigorously defend this matter.

In May 2012, Chun along with Natural Noble Limited (“Natural Noble”), which is a company that we believe is controlled by Chun (collectively, the "Natural Noble Plaintiffs"), obtained an ex parte decision from a Macau court allegedly enjoining one of our subsidiaries.  The injunction was requested and ordered against an alleged Australian entity named Shuffle Master Asia Limited, which entity does not exist, rather than our subsidiary SHFL Asia.  The injunction sought to prevent us from displaying any products that infringe the Natural Noble Plaintiffs’ patents during the 2012 G2E Asia Gaming Show, even though the decision did not specify which of our products displayed at the G2E Asia Gaming Show would allegedly infringe such patents.  After initially agreeing with Macau customs officials’ request to cover our  SHFL FUSION Hybrid Table Games unit, we received court approval to post a bond of approximately $0.1 million to enable our subsidiary SHFL Asia to display the  SHFL FUSION Hybrid Table Game unit at the G2E Asia Gaming Show.   In February 2013, SHFL Asia submitted arguments of appeal contesting the decision to grant the injunction to the Macau Second Instance Court. The Court dismissed the appeal on July 18, 2013 based on the fact that SHFL Asia is not the entity against which the injunction was granted, but rather the injunction was granted against the non-existent Australian entity named Shuffle Master Asia Limited. Therefore, the Court found that SHFL Asia did not have procedural standing to appeal the decision. Despite not being the party against which the injunction was granted, SHFL Asia believes it has the right to appeal the decision. SHFL Asia submitted an application for Appeal to the Macau Court of Final Appeal on August 2, 2013. We believe that we have meritorious claims and are vigorously pursuing the matter.

In June 2012, the Natural Noble Plaintiffs and LT Game Limited, a company that we believe is controlled by Chun (collectively, the “LT Game Plaintiffs”), filed a writ of summons with a Macau court seeking monetary damages and other civil relief as a result of the alleged infringement of the Natural Noble Plaintiffs’ patents by SHFL Asia and SHFL entertainment, Inc. at the 2012 G2E Asia Gaming Show.  A trial date has not yet been set for this matter. We believe that we have meritorious defenses, have submitted our defenses and counterclaims in this matter and are vigorously defending this matter.

In July 2012, LT Game International Ltd., a company that we believe may be controlled by Chun, filed a complaint against SHFL in the United States District Court for the District of Nevada alleging unfair competition and tortious interference with current and prospective business and contractual relations as a result of our alleged disparagement and misrepresentations regarding LT Game International Ltd.’s business, products and services.  The complaint seeks injunctive relief and an unspecified amount of damages, including claims for reasonable attorneys’ fees and disbursements, costs, statutory damages under the Lanham Act, treble damages and profits.  The parties are conducting discovery and a trial date has not yet been set for this matter. We believe that this complaint is without merit and we are vigorously defending this matter.

In October 2012, SHFL Asia filed a lawsuit with a Macau court against the LT Game Plaintiffs and Paradise Entertainment, Inc. (collectively “Paradise Defendants”), a company that we believe is the ultimate parent company of LT Game Limited and Natural Noble.  This lawsuit seeks an injunction against the Paradise Defendants’ assertions of monopolistic rights, whereby the Paradise Defendants claim that their respective patents cover multi-game terminal betting as a concept or generic invention.  The lawsuit alleges that the Paradise Defendants have made statements of such monopolistic rights, publicly and to SHFL Asia’s customers, to the detriment of SHFL Asia’s business and such statements claim patent protection beyond the legal scope of patent protection in Macau.  The lawsuit further alleges that the Paradise Defendants’ patents are not novel, and thus the Paradise Defendants cannot restrict SHFL Asia and others from selling or using multi-game terminal betting products in Macau.  A Trial Hearing began in June, 2013 and is scheduled to continue on September 9, 2013. We believe that we have a meritorious case and are vigorously pursuing this claim.

Litigation relating to the Proposed Merger – Shortly after the announcement of the proposed Merger, three complaints challenging the proposed Merger between the Company and Bally were filed in the Minnesota District Court, Fourth Judicial District, County of Hennepin:

Four similar cases also were filed in the Eighth Judicial District Court, County of Clark, Nevada:

Each of the foregoing actions is a putative class action or shareholder derivative action filed on behalf of the public shareholders of the Company and names as defendants the Company, its directors, Bally and Merger Sub except for the Rosenfeld action, which does not name Bally and Merger Sub as defendants. The complaints generally allege that the individual defendants breached their fiduciary duties in connection with their consideration and approval of the proposed Merger and the entity defendants aided and abetted those alleged breaches. The complaints seek, among other relief, declaratory judgment, damages and an injunction against the proposed Merger.

On August 9, 2013, the Minnesota actions were consolidated before Judge Mel Dickstein under the caption In re SHFL entertainment, Inc., No. 27-CV-13-13529. On August 16, 2013, all defendants moved to dismiss the Minnesota complaints on several grounds, including failure to state a claim on which relief may be granted and lack of standing. A hearing on the defendants’ motions is currently scheduled for October 23, 2013.  The Minnesota court has directed the Company to produce certain limited discovery before that date and plaintiffs to file any motion for injunctive relief by October 11, 2013 (which would then be heard at the same time as defendants' motions to dismiss).  

The outcome of these lawsuits cannot be predicted with any certainty. An adverse judgment for monetary damages could have a material adverse effect on the operations and liquidity of the Company. A preliminary injunction could delay or jeopardize the completion of the proposed Merger, and an adverse judgment granting permanent injunctive relief could indefinitely enjoin completion of the proposed Merger. All of the defendants believe that the claims asserted against them in the lawsuits are without merit and are defending against them vigorously. Additional lawsuits arising out of or relating to the Merger Agreement or the proposed Merger may be filed in the future.

We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of business. We do not believe the liabilities, if any, which may ultimately result from the outcome of such matters, individually or in the aggregate, will have a material adverse impact on our financial position, liquidity or results of operations.