ITEM 1. DESCRIPTION OF BUSINESS.
PDS Financial Corporation and subsidiaries (the "Registrant", the "Company" or "PDS"), was incorporated under the laws of the State of Minnesota in 1988.
The Company engages in the business of financing and leasing gaming equipment and supplying reconditioned gaming machines to casino operators. The gaming equipment financed by the Company consists mainly of slot machines, video gaming machines and other gaming devices. In addition, the Company finances furniture, fixtures and other gaming related equipment, including gaming tables and chairs, restaurant and hotel furniture, vehicles, security and surveillance equipment, computers and other office equipment. In 1996, the Company introduced SlotLease, a specialized operating lease program for slot machines and other electronic gaming devices. In 1997, the Company established PDS Slot Source, a reconditioned gaming machine sales and distribution division, to complement its leasing and financing activities.
In order to offer its SlotLease program and PDS Slot Source, the Company must be licensed to own and distribute gaming devices in each jurisdiction in which it conducts business. As part of the licensing process, each gaming jurisdiction performs a thorough investigation of each applicant and certain of its directors, officers, key employees and significant shareholders. The Company currently is licensed in Nevada, New Jersey, Colorado, Illinois, Iowa, Minnesota, Mississippi, Indiana and New Mexico. The Company also has a license application pending in Washington and a route operator's license application pending in Nevada. The Company believes its gaming licenses, as well as its experience in the gaming industry, provide a significant competitive advantage, enabling the Company to offer financing packages and services that meet the needs of this industry more effectively than traditional financing.
The Company was founded in 1988 as a leasing company, specializing in vehicle and general equipment leasing transactions. The Company began providing equipment financing for new Indian gaming facilities in the Upper Midwest in early 1991. Since 1994, all of the Company's gross originations have resulted from transactions in the gaming industry. In 1996, the Company established a sales office in Las Vegas, Nevada, which became the Company's principal executive office in 1997.
The Company generally targets established medium-sized casino operators that are opening new gaming facilities or expanding existing gaming facilities, as well as new casinos that the Company believes have acceptable credit quality. The Company also provides financing directly to gaming equipment manufacturers. The Company is currently focusing its efforts on the traditional gaming market of Nevada and the other jurisdictions in which it is licensed.
GAMING INDUSTRY
The casino industry in the United States, and the gaming industry in general, have experienced substantial growth in recent years. Prior to 1979, high stakes gaming activities were limited to Nevada. In 1979, casino gaming was legalized in New Jersey. Between 1979 and 1988, gaming activities by various Indian tribes developed, leading to the federal enactment of the Indian Gaming Regulatory Act of 1988. The growth of Indian gaming served as a catalyst for certain jurisdictions to consider non-Indian casino gaming because of its potential as a source of government revenue. Since 1989, various forms of casino gaming have been legalized in Colorado, Illinois, Indiana, Iowa, Louisiana, Michigan, Mississippi, Missouri and South Dakota. In addition, gaming facilities operate on cruise ships sailing out of California, Florida, Georgia, Hawaii and Puerto Rico. Several other states have approved or are considering approval of some form of casino gaming. No assurance can be given as to whether any additional states will adopt legislation permitting casino gaming in the future or the nature, timing and extent of casino development in any state.
According to data compiled from gaming commission reports and gaming industry analysts, in 1998 there were approximately 400,000 total gaming machines installed in the United States, compared with approximately 237,000 total gaming machines installed in the United States in 1993 and approximately 156,000 total gaming machines installed in the United States in 1990. According to data compiled from gaming commission reports and gaming industry analysts, in 1997 there were approximately 74,000 gaming machines shipped in the United States, compared with approximately 58,000 gaming machines shipped in the United States in 1993 and approximately 16,000 gaming machines shipped in 1990, all of which represent machines shipped to replace older machines and new installations of machines.
COMPANY STRATEGY
The Company believes that the gaming industry in general has entered into a gaming equipment replacement cycle, which provides increased opportunities for the Company's products and services. The Company believes its ability to offer casino operators gaming devices under operating lease structures provides a competitive advantage over non-licensed financial institutions. The Company's strategy is to increase its recurring revenues and cash flows by increasing its portfolio of assets under lease and its reconditioned gaming device sales by expanding the types of games it offers and by expanding into the direct operations of casinos. In 1999, the Company completed its move to Las Vegas, Nevada. The Company intends to further expand its presence in Nevada and the other jurisdictions in which it is licensed.
Because it is licensed to own and distribute gaming machines in key states, the Company believes it is able to offer a wider variety of gaming equipment financing structures, such as operating leases, which are especially important for small to medium-sized casino operators that may be subject to financing covenants that restrict indebtedness. While gaming equipment manufacturers and distributors may offer financing to a casino operator, this financing may not be on the most favorable terms, and the manufacturers and distributors generally do not offer sufficient financing for other necessary furniture, fixtures and equipment. The Company believes its experience in and knowledge of the industry, as well as its licenses, allow it to offer financing packages and services that meet the needs of the industry in a more effective manner than traditional financing and leasing sources and equipment manufacturers and distributors.
THE SLOTLEASE PROGRAM
The Company believes SlotLease, its operating lease program, has been well received by casino operators since its introduction in 1996 because it offers lower monthly payments and off-balance sheet financing. The Company believes that the SlotLease program promotes its strategic objective of increasing recurring revenues. The Company retains ownership of the gaming equipment under operating lease, and at the end of the applicable lease term the Company offers the customer an option to purchase the gaming equipment at its then determined fair market value or extend the lease term. The Company receives rental income under a non-cancelable lease, which ranges from 6 to 48 months and typically has a term of 36 months. The casino operator incurs rental expense, and avoids reflecting an asset and related liability on its balance sheet. Returned machines are inventoried for lease or resale by the Company through PDS Slot Source.
PDS SLOT SOURCE
In May 1997, the Company introduced PDS Slot Source, its reconditioned gaming machine sales and distribution division. The Company believes that the secondary market for gaming machines is fragmented and underdeveloped and Slot Source is now one of the leading providers of reconditioned gaming devices. The Company obtains used gaming machines in the market from distributors, brokers or operators, or from its customers at the end of an applicable lease term. These gaming machines are reconditioned by the Company prior to resale or occasionally are sold "as is" to customers. The Company believes its ability to recondition and distribute used gaming machines enhances the market value of gaming machines at the end of an operating lease and facilitates additional financing transactions.
During 1999, the Company expanded its focus beyond providing reconditioned slot and video gaming devices to include new types of games through the acquisition of intellectual property associated with "Digital 21", an automated computerized version of the traditional casino table game of "Blackjack". See discussion of the DigiDeal Technology Agreement below. The Company intends to continue to expand its gaming equipment offerings in the future through on-going development or acquisition of additional types of casino games.
DIGIDEAL
In June 1999, the Company acquired the intellectual property rights for gaming devices using the Digital Card System ("DCS") from DigiDeal Corporation as part of an agreement covering patent and technology rights including technology transfer, manufacture, distribution and affecting patents trademarks and copyrights (the Technology Agreement). Products built on the DCS platform use virtual playing cards, which are displayed with high quality graphics on screens for each player and the dealer. The first product introduced on the DCS platform is Digital 21-TM-, which is undergoing its first live trial in New Mexico and is presently being reviewed by the State of Nevada Gaming Control Board. There can be no assurance that the State of Nevada Gaming Control Board will approve Digital 21-TM- on a timely basis or at all. The Company's strategy is to place games utilizing the DCS with its casino customers in order to generate recurring monthly revenues and cash flows.
GAMING OPERATIONS
The Company intends to expand its business strategy to include owning and operating gaming facilities. In this regard, the Company on March 6, 2000, signed a nonbinding letter of intent with Elsinore Corporation to acquire the capital stock of Four Queens, Inc., a Nevada corporation doing business as the Four Queens Hotel & Casino for a purchase price of $30 million, subject to adjustment. Consummation of the acquisition is subject to a number of conditions, including negotiation and execution of a definitive purchase agreement, receipt of required regulatory approvals, including approval of the Nevada Gaming Commission, other gaming approvals, and, if necessary, approval under the Hart-Scott-Rodino Antitrust Act, and receipt by PDS of satisfactory purchase financing. There can be no assurance that a definitive agreement can be reached, the other conditions to the acquisition will be satisfied or that the acquisition will be consummated.
The Four Queens Hotel & Casino consists of a 690-room hotel and 32,000 square foot casino, located in the Fremont Street Experience in downtown Las Vegas, Nevada. The casino has approximately 1,075 slot machines and 26 table games. No material changes in the operations of the hotel and casino or personnel are anticipated.
STRUCTURE OF EQUIPMENT FINANCING TRANSACTIONS
In addition to offering operating leases through its SlotLease program, the Company also provides financing to its customers in the form of capital leases or collateralized loans. Such financing transactions are either originated directly by the Company with the casino operator or are structured jointly with the gaming equipment manufacturer or distributor. Under both of these types of transactions substantially all of the benefits and risks of ownership are borne by the lessee/borrower. Under a capital lease, the lessee is required to pay the Company the purchase price of the gaming equipment either throughout the term of the lease or, if the lease payments are not sufficient to cover the purchase price of the gaming equipment, the lessee is required to pay the Company a balloon payment at the end of the lease term. Most of the Company's equipment financing transactions range from $500,000 to $2.5 million. The Company generally obtains the funds necessary for its capital leases or collateralized loans by selling all or a portion of its interest in the payment stream to one or more institutional investors, often simultaneously with its origination of financing transactions.
COMPETITION
The finance industry is highly competitive. In the gaming equipment financing market, the Company competes primarily with equipment manufacturers, and to a lesser extent with leasing companies, commercial banks and other financial institutions. Certain of the Company's competitors are significantly larger and have substantially greater resources than the Company. The Company sometimes jointly markets its financing services with gaming equipment manufacturers who may be competitors of the Company. The Company believes its ability to offer casino operators gaming devices under operating lease structures provides a competitive advantage over non-licensed financial institutions.
The Company competes on the basis of offering flexibility in structuring leases and other financial transactions, commitment to prompt attention to customer needs, creative solutions to non-traditional financing requests and immediate reactions to changes in the financial marketplace. In addition to financing gaming equipment, the Company finances substantially all other types of furniture, fixture and equipment used in a casino operation.
With respect to the sales of reconditioned gaming machines, the Company competes primarily against equipment manufacturers and smaller distributors. It is possible that new competitors may engage in gaming equipment financing or the distribution of reconditioned gaming machines, some of which may have licenses to own or sell gaming equipment and have greater financial resources than the Company.
PRINCIPAL CUSTOMERS
Historically, the Company has experienced significant nonrecurring revenues in connection with the completion of large gaming equipment financing transactions. During 1999, no customer accounted for more than 10% of total revenue. Revenues from the Company's five largest customers, as a percentage of 1998 revenues were 20%, 19%, 16%, 9% and 8%, and of 1997 revenues, were 0%, 11%, 0%, 0% and 0%, respectively. Due to the non-recurring nature of its large gaming equipment financing transactions, the Company cannot estimate the potential significance of total revenues that may be derived from one or several customers in 2000.
GOVERNMENT REGULATION
Gaming is a highly regulated industry. The Company's gaming equipment financing activities are subject to federal and state regulation and oversight. In order to offer its SlotLease program and PDS Slot Source, the Company must be licensed to own and distribute gaming devices in each jurisdiction where it conducts business. As part of the licensing process, each gaming jurisdiction performs a thorough investigation of each applicant, its directors and certain of its officers, key employees and significant shareholders. The Company currently is licensed as a gaming equipment distributor under Nevada, New Jersey, Colorado, Illinois, Iowa, Mississippi, Minnesota, Indiana and New Mexico gaming laws. The Company has license applications pending in Washington and a slot route operator's license application pending in Nevada. Expansion of the Company's activities may be hindered by delays in obtaining requisite state licenses or other approvals. No assurance can be given as to the term for which the Company's license will be renewed in a particular jurisdiction or to what license conditions, if any, may be imposed by such jurisdiction in connection with any future renewals. The Company cannot predict the effect that such adoption of and changes in gaming laws, rules and regulations might have on its future operations.
Any person who acquires a controlling interest in the Company would have to meet the requirements of all applicable governmental bodies that regulate the Company's operations. A change in the make-up of the Company's board of directors and management would require the various gaming authorities to examine the qualifications of the new board members and management.
Gaming on Indian land is further regulated by tribal governments. Changes in federal, state or tribal laws or regulations may limit or otherwise materially affect the types of gaming that may be conducted on Indian land. In addition, numerous lawsuits nationwide seek to limit or expand Indian gaming activities. The outcome of such litigation cannot be predicted.
The following references to material statutes and regulations affecting the Company are brief summaries thereof and do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations. Any change in applicable law or regulation may have a material effect on the business of the Company.
NEVADA. The manufacture, ownership, operation, sale and distribution of gaming devices in Nevada is subject to the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, the "Nevada Act") and various local regulations. Generally, gaming activities (including the manufacture, sale and lease of gaming devices) may not be conducted in Nevada unless licenses are obtained from the Nevada Gaming Commission (the "Nevada Commission") and appropriate county and city licensing agencies. The Nevada Commission, the Nevada State Gaming Control Board (the "Nevada Board") and the various county and city licensing agencies are collectively referred to as the "Nevada Gaming Authorities."
The laws, regulations, and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (iv) the prevention of cheating and fraudulent practices; and (v) to provide a source of state and local revenues through taxation and licensing fees. Change in such laws, regulations, and procedures could have an adverse effect on the Company's operations.
PDS Financial Corporation-Nevada, a Nevada corporation and wholly owned subsidiary of the Company ("PDS Nevada"), is required to be licensed as a distributor by the Nevada Gaming Authorities. The gaming license requires the periodic payment of fees and taxes and is not transferable. The Company is registered by the Nevada Commission as a publicly traded corporation ("Registered Corporation") and as such, it is required periodically to submit detailed financial and operating
reports to the Nevada Commission and furnish any other information which the Nevada Commission may require. No person may become a stockholder of, or receive any percentage of profits from, PDS Nevada without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Company and PDS Nevada have obtained from the Nevada Gaming Authorities the various registrations, approvals, permits, and licenses required in order to engage in the distribution of gaming devices and to act as a manufacturer of gaming devises in Nevada. The Company also has an application pending with the Nevada Gaming Authorities for a slot route operator's license.
The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, the Company or PDS Nevada in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of PDS Nevada must file applications with the Nevada Gaming Authorities and may be required to be licensed or found suitable by the Nevada Gaming Authorities. Officers, directors, and key employees of the Company who are actively and directly involved in gaming activities of PDS Nevada may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation incurred by the Nevada Gaming Authorities. Changes in licensed positions must be reported to the Nevada Gaming Authorities and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a change in corporate position.
If the Nevada Gaming Authorities were to find an officer, director, or key employee unsuitable for licensing or unsuitable to continue having a relationship with the Company or PDS Nevada, the company involved would have to sever all relationships with such person. In addition, the Nevada Commission may require the Company or PDS Nevada to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada.
The Company and PDS Nevada are required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities, and similar financial transactions by PDS Nevada must be reported to, or approved by, the Nevada Commission.
If it were determined that the Nevada Act was violated by PDS Nevada, the gaming licenses it holds could be limited, conditioned, suspended, or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, PDS Nevada, the Company, and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Limitation, conditioning, or suspension of any gaming license could (and revocation of any gaming license would) materially adversely affect the Company's operations.
Any beneficial holder of the Company's voting securities, regardless of the number of shares owned, may be required to file an application, be investigated, and have his suitability as a beneficial holder of the Company's voting securities determined if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation.
The Nevada Act requires any person who acquires more than five percent of the Company's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires the beneficial owners of more than 10 percent of the Company's voting securities apply to the Nevada Commission for a finding of suitability within 30 days after the chairman of the Nevada Board mails the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10 percent, but not more than 15 percent, of the Company's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the Company, any change in the Company's corporate charter, bylaws, management, policies, or operations of the Company, or any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the Company's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies, or operations; and (iii) such other activities as the Nevada Commission may
determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership, or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of the investigation incurred by the Nevada Gaming Authorities.
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board, may be found unsuitable. A record owner may also be found unsuitable if the record owner fails to identify the beneficial owner within 30 days of a request by the Nevada Commission or Chairman of the Nevada Board. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock of a Registered Corporation beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Company is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Company or PDS Nevada, the Company (i) pays that person any dividend or interest upon voting securities of the Company, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) pays remuneration in any form to that person for services rendered or otherwise, or (iv) fails to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities for cash at fair market value.
The Nevada Commission may, in its discretion, require the holder of any debt security of a Registered Corporation to file applications, be investigated, and be found suitable to own the debt security of a Registered Corporation. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i)pays to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii)recognizes any voting right by such unsuitable person in connection with such securities; (iii)pays the unsuitable person remuneration in any form; or (iv)makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction.
The Company is required to maintain a current stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable.
The Company is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require the Company's stock certificates to bear a legend indicating that the securities are subject to the Nevada Act. However, to date, the Nevada Commission has not imposed such a requirement on the Company.
The Company may not make a public offering of its securities without the prior approval of the Nevada Commission if the securities or proceeds therefrom are intended to be used to construct, acquire, or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. "Gaming facilities" has been interpreted by the Nevada Gaming Authorities to include the acquisition or financing of gaming devices in Nevada. Furthermore, any such approval, if granted, does not constitute a finding, recommendation, or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful.
Changes in control of the Company through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and Nevada Commission in a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors, and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction.
The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada gaming licensees, and Registered Corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i)assure the financial stability of corporate gaming operators and their affiliates; (ii)preserve the beneficial aspects of conducting business in the corporate form; and (iii)promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Company can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of
recapitalization proposed by the Company's Board of Directors in response to a tender offer made directly to the Registered Corporation's stockholders for the purposes of acquiring control of the Registered Corporation.
License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to the counties and cities in which the Nevada licensee's respective operations are conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly, or annually. Nevada licensees that hold a license as an operator of a slot route, or a manufacturer's or distributor's license, also pay certain fees and taxes to the State of Nevada.
Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada is required to submit a notification statement to the Nevada Board which provides detailed information regarding the foreign gaming operation and to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation of the Nevada Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. A Licensee is also subject to disciplinary action by the Nevada Commission if it knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability.
NEW JERSEY. The Company and certain of its officers and directors, are currently required to be licensed under the New Jersey Casino Control Act (the "New Jersey Act") as a casino service industry qualified to sell its products to casinos in New Jersey. The sale and distribution of gaming equipment to casinos in New Jersey is also subject to the New Jersey Act and the regulations promulgated thereunder by the New Jersey Commission. The New Jersey Commission has broad discretion in promulgating and interpreting regulations under the New Jersey Act. Amendments and supplements to the New Jersey Act, if any, may be of a material nature, and accordingly may adversely affect the ability of the Company or its employees to obtain any required licenses, permits and approvals from the New Jersey Commission, or any renewals thereof.
The current regulations govern licensing requirements, standards for qualification, persons required to be qualified, disqualification criteria, competition, investigation of supplementary information, duration of licenses, record keeping, causes for suspension, standards for renewals or revocation of licenses, equal employment opportunity requirements, fees and exemptions. In deciding to grant a license, the New Jersey Commission may consider, among other things, the financial stability, integrity, responsibility, good character, reputation for honesty, business ability and experience of the Company and its directors, officers, management and supervisory personnel, principal employees and stockholders as well as the adequacy of the financial resources of the Company.
New Jersey licenses are granted for a period of one or two years, depending on the length of time a company has been licensed, and are renewable. The New Jersey Commission may impose such conditions upon licensing, as it deems appropriate. These include the ability of the New Jersey Commission to require the Company to report the names of all of its stockholders as well as the ability to require any stockholders whom the New Jersey Commission finds not qualified to dispose of the stock, not receive dividends, not exercise any rights conferred by the shares, nor receive any remuneration from the Company for services rendered or otherwise. Failure of such stockholder to dispose of such stockholder's stock could result in the loss of the Company's license. Licenses are also subject to suspension, revocation or refusal for sufficient cause, including the violation of any law. In addition, licensees are also subject to monetary penalties for violations of the New Jersey Act or the regulations of the New Jersey Commission.
OTHER JURISDICTIONS. In addition to Nevada and New Jersey, the Company currently is licensed to operate at various levels in Colorado, Illinois, Indiana, Iowa, Minnesota, Mississippi and New Mexico and has license applications pending in Washington. Although the regulations in these jurisdictions are not identical to the states of Nevada or New Jersey, their material attributes are substantially similar, as summarized below.
The manufacture, sale and distribution of gaming devices and the ownership and operation of gaming facilities in each jurisdiction are subject to various state, county and/or municipal laws, regulations and ordinances, which are administered by the relevant regulatory agency or agencies in that jurisdiction (the "Gaming Regulators"). These laws, regulations and ordinances primarily concern the responsibility, financial stability and character of gaming equipment owners, distributors,
sellers and operators, as well as persons financially interested or involved in gaming or liquor operations.
In many jurisdictions, selling or distributing gaming equipment may not be conducted unless proper licenses are obtained. An application for a license may be denied for any cause which the Gaming Regulators deem reasonable. In order to ensure the integrity of manufacturers and suppliers of gaming supplies, most jurisdictions have the authority to conduct background investigations of the Company, its key personnel and significant stockholders. The Gaming Regulators may at any time revoke, suspend, condition, limit or restrict a license for any cause deemed reasonable by the Gaming Regulators. Fines for violation of gaming laws or regulations may be levied against the holder of a license and persons involved. The Company and its key personnel have obtained all licenses necessary for the conduct of the Company's business in the jurisdictions in which it sells, distributes and finances gaming equipment. Suspension or revocation of such licenses could have a material adverse effect on the Company's operations.
EMPLOYEES
As of December 31, 1999, the Company employed 52 persons, including 7 in direct sales and marketing, 28 in Slot Source and 17 in general and administrative functions. All of these persons are full-time employees.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's corporate offices and its reconditioning facilities are located in approximately 58,000 square feet of leased space in Las Vegas, Nevada. The Company pays monthly rent of approximately $40,000 pursuant to a lease expiring on December 31, 2004. The Company considers the facilities as adequate and suitable for the purposes they serve.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any material litigation and is not aware of any threatened litigation that would have a material adverse effect on its business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 1999, no matter was submitted to a vote of security holders.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Common Stock is traded on the NASDAQ SmallCap Market under the symbol: PDSF. The following table sets forth the high and low sales price for the Common Stock as reported by NASDAQ for the periods indicated. These prices reflect inter-dealer prices, without retail mark-up or markdown or commissions, and do not necessarily represent actual transactions.
On March 21, 2000, the most recent available trading date, the closing sales price of the Company's common stock was $1.3125. As of March 21, 2000, the Company's common stock was held by approximately 42 holders of record and an estimated 700 additional beneficial owners.
No dividends were paid during the periods indicated. The Company does not anticipate that it will pay cash dividends on its common stock in the foreseeable future. Certain of the Company's financing agreements restrict the payment of dividends.
In December, 1999 NASDAQ informed the Company that it was not in compliance with the $5 million market value of public float requirement for continued listing of its Common Stock on the NASDAQ National Market. Subsequently, the Company applied for listing on the NASDAQ SmallCap Market. By letter dated March 8, 2000, NASDAQ informed the Company that its application for listing on the NASDAQ SmallCap Market had been approved.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The table below sets forth-selected consolidated financial data for the periods indicated derived from the Company's consolidated financial statements. The data should be read in conjunction with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and the Company's consolidated financial statements and notes to the financial statements appearing elsewhere.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW:
The Company is engaged in the business of financing and leasing gaming equipment and supplying reconditioned gaming devices to casino operators. The gaming equipment financed by the Company consists primarily of slot machines, video gaming machines and other gaming devices. In addition, the Company finances furniture, fixtures and other gaming related equipment, including gaming tables and chairs, restaurant and hotel furniture, vehicles, security and surveillance equipment, computers and other office equipment. In 1996, the Company introduced SlotLease, a specialized operating lease program for slot machines and other electronic gaming devices. The Company believes it is currently the only independent leasing company licensed in the states of Nevada, New Jersey, Colorado, Illinois, Iowa, Indiana, Mississippi, Minnesota and New Mexico to provide this financing alternative. In 1997, the Company established PDS Slot Source, a reconditioned gaming device sales and distribution division, to complement its leasing and financing activities and to generate equipment sales to casino operators.
The Company's strategy is to increase its portfolio of assets under lease and reconditioned gaming device sales, and thereby increase revenues and cash flows. In addition to its leasing activities, the Company also originates note transactions, which it generally sells to institutional investors for fee income. In some of its transactions, the Company holds the leases or notes for a period of time after origination, or retains a partial ownership interest in the leases or notes. The Company believes its ability to recondition and distribute used gaming devices enhances the gaming devices' values at the end of an operating lease and facilitates additional financing transactions. In the last three years, the Company has significantly increased the amount of leases and collateralized equipment loans ("financing transactions") held in its own portfolio (in thousands):
RESULTS OF OPERATIONS:
During 1999, 1998, and 1997 the Company reported net (loss) income of ($734,000), $356,000 and $942,000, respectively.
The results of operations for 1999 and 1998 reflect:
- - - Costs associated with growing the business activities of the PDS Slot Source division, which was established in 1997. During 1999, the Company incurred a loss of $669,000, as a result of liquidating certain used gaming devices held in inventory by Slot Source.
- - - The costs associated with growing the portfolio of financing transactions retained on its balance sheet. Such costs include:
- Higher interest expense associated with the debt incurred to finance the portfolio, and
- The opportunity cost resulting from foregone fee income which could have been realized had the financing transactions been sold to third parties, compared to the leasing or finance margin actually realized from holding the financing transactions in the Company's portfolio. While the aggregate leasing and finance margin is expected to be greater over the life of the transaction, it is significantly less than fee income would have been in the year of origination.
Results for 1997 reflect sales-type lease profit arising from the Company's ability to buy new gaming devices from the manufacturer at a discount. After 1997, no such transactions were completed.
The Company's operating results are subject to quarterly fluctuations resulting from a variety of factors, including variations in the mix of financing transactions between operating leases, direct finance leases, and notes receivable, changes in the gaming industry which effect the demand for reconditioned gaming devices sold by the Company's Slot Source division,
economic conditions, in which a detrimental change can cause customers to delay new investments and increase the Company's bad debt experience, and the level of fee income obtained through the sale of leases or financing transactions.
The Company's quarterly operating results, including net income (loss), have historically fluctuated due to the timing of completion of large financing transactions, as well as the timing of recognition of the resulting fee income upon subsequent sale. These transactions can be in the negotiation and documentation stages for several months, and recognition of the resulting fee income by the Company may fluctuate greatly from quarter to quarter. Thus, the results of any quarter are not necessarily indicative of the results, which may be expected for any other period. The Company believes that growth of its portfolio of notes and lease receivables and equipment under operating lease will lead to increased recurring revenues, which will tend to lessen the fluctuations of its operating results.
Presented below are schedules showing condensed income statement categories and analysis of changes in those condensed categories derived from the Consolidated Statements of Income appearing on page of this report on Form 10-K, prepared solely to facilitate the discussion of results of operations that follows (in thousands):
EQUIPMENT SALES AND SALES-TYPE LEASE MARGIN
Equipment sales and sales-type margin consist of the following (in thousands):
Slot Source Division
Slot Source revenues represent the sale, or financing under a sales-type lease to an end-user, of reconditioned gaming equipment. During 1998, the Company significantly expanded its efforts in this area resulting in significantly increased sales compared to 1997, primarily related to sales of reconditioned gaming devices with a feature known as a "bill acceptor" (a device which enables a machine to accept paper currency in addition to coins) for which there was strong market demand. The market demand for such gaming devices was significantly satisfied during 1998. Additionally, demand for "reel-type" slot machines declined in 1999. Consequently, revenues and sales margin declined in 1999. In response to these trends, the Company has significantly narrowed its product line and managed Slot Source inventory levels downward (from $10 million to $6.6 million at December 31, 1998 and 1999, respectively) by liquidating at a loss of $669,000 gaming devices for which market demand had declined, and by establishing more stringent guidelines for acquiring used gaming devices for inventory.
Finance Division
The Company realizes gains upon lease termination in two ways:
- The Company's operating lease agreements generally provide the lessee with the option to purchase the leased equipment upon lease expiration at its then fair market value. The Company realizes a gain where the lessee acquires the equipment for fair market value in excess of the Company's residual carrying value, or
- An existing lessee chooses to terminate a lease prior to its scheduled expiration. The lessee is generally required to pay the Company an amount in excess of its carrying value in such situations. Sales revenue in 1998 primarily reflects early termination transactions. There were no such transactions during 1999.
The Company believes that, due to increasing lease maturities in the future, it will realize gains on termination of leases in calendar year 2000.
Sales-type lease revenue from third party gaming devices and associated equipment was $14.5 million and cost of sales-type leases was $13.7 million in 1997. The Company completed no such transactions in 1999 and 1998. Such amounts were excluded from the Equipment Sales and Sales-type Lease Margin table above due to their non-recurring nature.
LEASING AND FINANCE MARGIN
Leasing and finance margin consists of the following (in thousands):
Leasing and finance margin and it's components have increased in 1999 and in 1998, and are expected to increase in the future due to increases in the Company's portfolio of operating leases, direct finance leases, and collateralized equipment loans as summarized below (in thousands):
Leasing and finance margin has not increased as quickly as the lease and finance portfolio because of:
- Changes in the mix of leases and financing transactions originated during 1999 and 1998. An increase in the mix of operating leases compared to direct financing leases and collateralized loans moderated the growth in the related margin. Operating lease margin (rental revenue less depreciation) is recognized on a constant basis over the life of a lease. Finance income is recognized as a fixed percentage of the underlying balance of the note receivable or direct finance lease. Consequently, the margin inherent in an operating lease tends to be recognized later in the life of the lease when compared to a note receivable or a direct finance lease. Therefore, as the portfolio has grown to include a greater percentage of operating leases, leasing margin has not grown to the same extent or as quickly.
- The timing of the completion of significant lease and finance originations and terminations. A significant customer terminated their leases in late 1997. Thus, the Company recognized lease margin throughout most of 1997, but the asset was sold at year end. The gain on termination of leases was reflected in equipment sales and sales-type lease margin in 1997.
FEE INCOME
Fee income includes gross profit form the sale to third parties of the Company's interest in notes receivable and direct finance leases. Upon sale, the Company records fee income equal to the difference between the sale price and the carrying value of the related asset. Fee income also includes commissions earned for arranging financing between unrelated parties. Fee income has historically fluctuated due to the timing of completion of large financing transactions, as well as the timing of the subsequent sale of notes receivable and direct finance leases. Fee income decreased $924,000 in 1998 compared to 1997, primarily due to the Company's strategy of holding more transactions for its own account and consequently fewer transactions were sold for fee income. The strategy of holding more transactions continued in 1999, however, fee income increased due to transactions with one customer which resulted in approximately 45% of the year's fee income.
INTEREST EXPENSE
Consistent with the Company's plan to grow its lease portfolio, it has incurred higher levels of borrowing, and consequently incurred an increase in interest expense, to finance the investment in leases and notes receivable.
SELLING, GENERAL & ADMINISTRATIVE, EXPENSES
The increases in selling, general & administrative expenses in 1999 and 1998 primarily reflect higher payroll and occupancy costs associated with the growth in the Slot Source reconditioned gaming device division, and legal fees associated with obtaining licensing in the states of Mississippi and Illinois in 1999, and Colorado in 1998, and legal fees in connection with the work out of three accounts which defaulted in 1999.
PROVISION FOR LOSSES
The provision for losses represents the Company's estimate of the amount expected to be lost related to specific accounts, including estimated losses on future non-cancelable lease rentals and notes receivable. The 1999 provision for loss reflects three customers that defaulted under their financing agreements.
INCOME TAXES
The Company's effective tax rate was approximately 26% for 1999, and lower than the federal statutory rate of 34% due to the non-deductible amortization of costs related to the acquisition of the DigiDeal Technology Agreement and the reversal of temporary differences at other than the originally expected effective rate.
The Company's effective income tax rate was approximately 38% in both 1997 and 1998. Effective rates for 1998 and 1997 are higher than the federal statutory rate of 34%, due primarily to state income taxes.
LIQUIDITY AND CAPITAL RESOURCES:
The Company's unrestricted cash and cash equivalents totaled $2.9 million at December 31, 1999, compared to $1.3 million at December 31, 1998. Net cash provided by operations activities amounted to $2.3 million in 1999, compared to net cash used in operating activities of $16.8 million in 1998. The increase in cash provided by operating activities in 1999 resulted primarily the cash flow arising from the increase in the Company's portfolio of leases and notes receivable.
The Company's strategy to increase its financing activities involve a higher level of investment in notes receivable and equipment under operating leases. The funds necessary to support the Company's activities have been provided by cash flows generated primarily from the operating activities described above and various forms of recourse and non-recourse borrowings from banks, financial institutions, and financial intermediaries. Payments under the Company's borrowings and the maturities of its borrowings are typically structured to match the payments under the leases and notes collateralizing the borrowings.
See Note 4 to Notes to Financial statements for a description of the Company's debt financing.
The Company's current financial resources, including estimated cash flows from operations, the revolving credit and working capital and other facilities which total $71 million (of which $31 million is available as of December 31, 1999) are expected to be sufficient to fund the Company's anticipated working capital needs. In addition to the borrowing activities described above, the Company has developed a network of financial institutions to which it sells financial transactions on a regular basis. The Company manages its portfolio to optimize concentration among customers or geographic markets. To achieve this goal, it will from time to time, sell or externally finance transactions originated including those held in its investment portfolio. The Company continues to explore other possible sources of capital, however, there is no assurance that additional capital, if required, can be obtained or will be available on terms acceptable to the Company.
The Company has entered into a letter of intent to acquire the capital stock of Four Queens, Inc., which is contingent upon the Company obtaining satisfactory purchase financing. There can be no assurance that the Company will be able to obtain such financing on terms acceptable to the Company.
Inflation has not had a significant impact on the Company's operations.
FORWARD-LOOKING STATEMENTS:
Certain statements contained herein constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of terminology such as "believe," "may," "will," "expect," "anticipate," "intend," "designed," "estimate," "should" or "continue" or the negatives thereof or other variations thereon or comparable terminology. Such forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements express or implied by such forward-looking statements. Such factors include, among other things, the following: strict regulation by gaming authorities; competition the Company faces or may face in the future; uncertainty of market acceptance of the SlotLease program and PDS Slot Source; the ability of the Company to continue to obtain adequate financing; the ability of the Company to recover its investment in gaming equipment leased under operating leases as well as its investment in used gaming machines purchased for refurbishment and resale to customers; the risk of default with respect to the Company's financing transactions; the Company's dependence on key employees; potential fluctuations in the Company's quarterly results; general economic and business conditions; and other factors detailed from time to time in the Company's reports filed with the Securities and Exchange Commission.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Substantially all of the Company's borrowings are under fixed interest rates, and maturities are matched with the cash flows of leased assets and notes receivables. In addition, a changing interest rate environment will not impact the Company's margins since the effects of higher or lower borrowing costs would be reflected in the rates for newly originated leases or collateralized loans. Therefore, consistent with the Company's strategy and intention to hold most of its originations to maturity the Company does not have a significant exposure to interest rate changes.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS.
The company's Consolidated Financial statements, including notes thereto, are listed in Part IV, Item 14, of this report and are included after the signature page beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
On October 23, 1999 the Company determined to solicit proposals from qualified firms to act as the Company's independent auditors for the 1999 calendar year. On November 8, 1999, PricewaterhouseCoopers resigned as the independent accountants of the Company. There were no disagreements with PricewaterhouseCoopers on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of PricewaterhouseCoopers, would have caused them to make a reference to their report on financial statements for such years.
On January 5, 2000, the Company engaged new independent accountants, Piercy, Bowler, Tayler & Kern Certified Public Accountants & Business Advisors A Professional Corporation ("Piercy Bowler") to audit the Company's financial statements as of, and for the year ended, December 31, 1999. The decision to appoint Piercy Bowler was approved by the Audit Committee of the Board of Directors.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information required by this Item is incorporated by reference to the Company's definitive proxy statement to be filed within 120 days after the Company's fiscal year end.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to the Company's definitive proxy statement to be filed within 120 days after the company's fiscal year end.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this Item is incorporated by reference to the Company's definitive proxy statement to be filed within 120 days after the company's fiscal year end.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference to the Company's definitive proxy statement to be filed within 120 days after the company's fiscal year end.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements
The financial statements listed on the accompanying Index of Financial Statements (page) are filed as part of this annual report.
(b) Reports on Form 8-K
During the quarter ended December 31, 1999, the Company filed a Form 8-K regarding the resignation of PricewaterhouseCoopers LLP as the Company's accountants, as discussed under ITEM 9 above.
(c) Exhibits
Included as Exhibits are the items listed in The Exhibit Index. The Company will furnish to its shareholders of record as of the record date for its 1999 Annual Meeting of Stockholders, a copy of any of the exhibits listed below upon payment of $.25 per page.
EXHIBIT INDEX
--------------- (1) Incorporated by reference to the Registrant's previously filed Form SB-2 Registration Statement No. 33-76948C (2) Incorporated by reference to the Registrant's previously filed Form SB-2 Registration Statement No. 33-88692 (3) Incorporated by reference to the Registrant's previously filed Form 10-KSB for the year ended December 31, 1995 (4) Incorporated by reference to the Registrant's previously filed Form 10-KSB for the year ended December 31, 1997 (5) Incorporated by reference to the Registrant's previously filed Form 10-QSB for the quarter ended June 30, 1998 (6) Incorporated by reference to the Registrant's previously filed post effective amendment on Form S-3 to Form SB-2 Registration Statement No. 333-49199 (7) Incorporated by reference to the Registrant's previously filed Form 10-Q for the quarter ended September 30, 1999
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PDS Financial Corporation
By: /s/ Johan P. Finley Date: March 29, 2000 ------------------------------------- Johan P. Finley, Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has also been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 29, 2000.
Name Title ---- -----
By /s/ Johan P. Finley Chairman of the Board, -------------------------- Chief Executive Officer, Johan P. Finley President and Director (Principal Executive Officer)
By /s/ Peter D. Cleary Director, -------------------------- President, Peter D. Cleary Chief Operating Officer Interim Chief Financial Officer
By /s/ Joel M. Koonce Director -------------------------- Joel M. Koonce
By /s/ James L. Morrell Director -------------------------- James L. Morrell
By /s/ Lona M. Finley Director -------------------------- Lona M.Finley
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of PDS Financial Corporation:
We have audited the accompanying consolidated balance sheet of PDS Financial Corporation and subsidiaries as of December 31, 1999 and related consolidated statements of income (loss) and comprehensive income (loss), and stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of PDS Financial Corporation and subsidiaries as of December 31, 1999, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles.
PIERCY BOWLER TAYLOR & KERN Certified Public Accountants and Business Advisors, A Professional Corporation
Las Vegas, Nevada March 8, 2000
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of PDS Financial Corporation:
In our opinion, the accompanying balance sheet as of December 31, 1998 and the related consolidated statements of income and comprehensive income, stockholders' equity and cash flows for each of the two years in the period ended December 31, 1998 present fairly, in all material respects, the financial position, results of operations and cash flows of PDS Financial Corporation and subsidiaries (the "Company") at December 31, 1998 and for each of the two years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of PDS Financial Corporation and subsidiaries for any period subsequent to December 31, 1998.
PricewaterhouseCoopers LLP
Las Vegas, Nevada February 23, 1999
PDS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998
See notes to consolidated financial statements.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS) YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
See notes to the consolidated financial statements.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997
See notes to the consolidated financial statements.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
See notes to the consolidated financial statements.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS DESCRIPTION. PDS Financial Corporation and subsidiaries (the "Company") engages principally in the leasing and financing of gaming equipment. Beginning in 1997, the Company began reconditioning for disposition gaming equipment that it acquired at the end of the lease or through open market purchases. This reconditioning process and related sales and distribution effort (known as PDS Slot Source, an operating division) is viewed by management as an integral part of the Company's leasing and financing activities. The Company's specialized operating lease program for slot machines and other electronic gaming devices has been known as SlotLease since 1996. The Company conducts its leasing and financing and sales activities in substantially all domestic United States gaming jurisdictions and, to a lesser extent, certain other countries and could be affected by adverse changes in economic conditions in those areas.
USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenue and expenses during the reporting period. For the Company, these are principally the estimates of residual values, collectibility of notes, accounts, and leases receivable and valuation of equipment held for sale or lease. Actual results could differ from these estimates.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of PDS Financial Corporation and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
REVENUE AND COST RECOGNITION. The Company's leasing activities include operating, direct finance, sales-type, and leveraged leases. For all types of leases, the determination of profit considers the estimated value of equipment at lease termination, referred to as the residual value. For operating leases, revenue and depreciation on the leased equipment are recorded on the straight-line method over the term of the lease. Direct finance and sales-type leases are similar in that substantially all of the benefits and risks of ownership of the leased equipment are transferred to the lessee, and interest income is recognized at a constant percentage return on the asset carrying value. The carrying value consists of the present value of the future lease payments plus any unguaranteed residual, sometimes referred to herein as the lease receivable. A dealer's profit or loss on the subject equipment is recognized at the inception of a sales-type lease. Investment in leveraged leases consists of rentals receivable (net of principal and interest on nonrecourse debt), plus the estimated residual values of the equipment, and minus unearned income which is recognized at a constant percentage return on the investment over the lease term. After the inception of a lease, the Company may discount or sell notes and future lease payments to reduce or recover its investment in the asset.
Initial direct costs related to leases and notes receivable are capitalized as part of the related asset and amortized over the term of the agreement using the interest method, except for operating leases, for which the straight line method is used.
Equipment, consisting primarily of gaming devices, held for lease or sale is valued at the lower of average unit cost or net realizable value. Revenue is recognized when title transfers to the customer upon shipment of reconditioned gaming devices or upon the exercise of a purchase option under an operating lease.
FEE INCOME. The difference between the sale price and the carrying value of the notes and lease receivables sold is included in fee income. Fee income also includes commissions earned for arranging financing between unrelated parties.
CASH EQUIVALENTS. The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents consist of investments in money market accounts. Excluded from cash equivalents at December 31, 1999 and 1998 is restricted cash consisting of proceeds from borrowings legally restricted for certain transactions and expected to be completed within three months or less of such dates.
OTHER ASSETS, NET. Property and equipment is included in this classification and consists primarily of furniture, equipment and leasehold improvements stated at cost less depreciation and amortization calculated using the straight-line method over the estimated useful lives. Also included are direct costs incurred in obtaining debt that are being amortized over the term of the underlying financing agreement using the interest method and costs to obtain licenses to own and distribute gaming devices and associated equipment that are amortized over three years on a straight-line basis.
ALLOWANCE FOR LOSSES. An allowance for losses is maintained at levels determined by management to adequately provide for any other-than-temporary declines in asset values. In determining losses, economic conditions, the activity in used equipment markets, the effect of actions by equipment manufacturers, the financial condition of customers, the expected courses of
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
action by lessees with regard to leased equipment at termination of the initial lease term, changes in technology and other factors which management believes are relevant, are considered. Recoverability of an asset value is measured by a comparison of the carrying amount of the asset to future net cash flows expected to be generated by the asset. If a loss is indicated, the loss to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair valued of the asset. Asset charge-offs are recorded upon the disposition of the underlying assets. Assets are reviewed quarterly to determine the adequacy of the allowance for losses.
NET INCOME (LOSS) PER SHARE. The Company calculated basic and diluted net income (loss) per share as follows for the years ended December 31:
Options to purchase 802,000 shares of common stock, and warrants to purchase 1,290,000 shares of common stock were not included in the computation of diluted earnings per share for 1999 because the effect would be anti-dilutive. In addition, the exercise price was greater than the average market price of the common stock for the year. The weighted average exercise price for these options and warrants was $4.71 and $9.44 as of December 31, 1999. These options and warrants expire at various dates through 2009. Weighted-average exercise prices ($11.28 in 1998 and $5.60 in 1997) in excess of average market prices caused options and warrants to purchase common shares (984,500 in 1998 and 337,200 in 1997) to be excluded from the computation of diluted earnings in those years.
STOCK COMPENSATION. The Company accounts for stock based employee compensation (Note 7) using the intrinsic value method in Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES.
RECLASSIFICATIONS. Certain items in the consolidated financial statements have been reclassified to conform to the current year presentation.
2. NOTES, ACCOUNTS, AND LEASES RECEIVABLE:
Notes, accounts, and leases receivable consist of the following as of December 31:
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. NOTES, ACCOUNTS, AND LEASES RECEIVABLE (CONTINUED):
Notes and direct finance lease receivables are due in monthly installments, generally collateralized by casino-related equipment and furnishings. The Company is also committed to fund up to $5,000,000 under an unsecured revolving line of credit receivable in monthly installments of principal and interest of approximately $86,000. Leveraged leases net includes estimated residuals of $6,557,000 and deferred tax liabilities associated with these leases are not material.
At December 31, 1999, future minimum payments receivable on notes and leases (both direct finance leases and the leveraged leases) are as follows:
Included in the preceding table are notes and leases receivable from two customers totaling $4,053,000 (all in 2000) upon which no payments are currently being received. At December 31, 1999, specific allowances for doubtful collection provided for these and receivables from two other customers totaled $2,337,000. The maximum losses that the Company would incur if these customers failed to completely perform and the collateral were unavailable or of no value would be $1,716,000 after allowances provided. At December 31, 1998, specific allowances relating to one of these customers totaled $1,200,000. Interest income earned (and received) on impaired notes receivable for 1999, 1998 and 1997 was not material.
Changes in the allowance for uncollectible receivables are as follows:
The estimated fair value of notes and direct finance leases receivable approximates their carrying value. The fair value is estimated using discounted cash flow analysis and interest rates currently offered by the Company for obligations with similar terms and credit risk.
3. EQUIPMENT UNDER OPERATING LEASES AND DISCOUNTED LEASE OBLIGATIONS:
Equipment under operating leases consists of gaming equipment and casino hotel related equipment leased for periods ranging from 6 to 48 months as follows:
Lessees generally have the future right to purchase the equipment for fair value at the termination of the lease.
At December 31, 1999, future minimum lease payments to be received by the Company on non-discounted operating leases for the years ending December 31, 2000 through 2003 are approximately $14,086,000, $11,817,000, $8,361,000, and $2,712,000 respectively.
On occasion, the Company collateralizes borrowings from financial institutions with operating lease rentals and the related equipment. The borrowings at December 31, 1999 and 1998 are not material and are classified as notes payable in the accompanying consolidated balance sheet.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. EQUIPMENT UNDER OPERATING LEASES AND DISCOUNTED LEASE OBLIGATIONS (CONTINUED):
Interest expense on discounted lease obligations totaled $43,000, $274,000, and $1,976,000 in 1999, 1998 and 1997, respectively. At December 31, 1999, the effective interest rates on discounted lease rentals ranged from 8.7% to 10.5%.
4. NOTES PAYABLE AND SUBORDINATED NOTES:
Recourse and non-recourse obligations consist of the following:
Principal and interest payments on the recourse and nonrecourse notes payable are generally due monthly in amounts that are approximately equal to the total payments due from the lessee under the leases that collateralize the notes payable. Under recourse financing, in the event of a default by a lessee, the lender has recourse against the lessee, the equipment serving as collateral, and the borrower. Under nonrecourse financing, in the event of a default by a lessee, the lender generally only has recourse against the lessee, and the equipment serving as collateral, but not against the borrower.
Certain of the Company's lines of credit restrict the payment of dividends. The also contain certain covenants regarding minimum consolidated tangible net worth, maximum recourse debt to worth ratio, cash flow coverage, and minimum interest expense coverage ratio.
Recourse equipment notes include borrowings of $2.8 million at December 31, 1999, which have been funded by the lending source into escrow. The funding amounts are classified as restricted cash. Such amounts will be released from escrow and utilized to pay for equipment under lease as lease schedules are originated.
In May 1998, the Company issued $13,800,000 of 10% senior subordinated notes due on July 1, 2004 that included 690,000 detachable stock purchase warrants with an exercise price of $12.25 valued at $690,000 ($477,000 unamortized as of December 31, 1999). Interest is payable quarterly. Pursuant to the terms of the indenture, beginning July 1, 2000, a total of $2.1 million of the subordinated notes will be randomly selected each year for mandatory redemption. In addition to mandatory redemptions, the Company may also redeem the subordinated notes, in part or in full, at any time at par plus accrued interest and any premium, if applicable. The entire unpaid principal balance and unpaid interest thereon, is due and payable on July 1, 2004.
In 1993, the Company issued unsecured subordinated debentures convertible into shares of common stock of the Company using a per share conversion price of $4.25. During 1998 and 1997, approximately $50,000 and $1,020,400 of debentures were converted into 11,810 and 240,220 shares of common stock.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Recourse and nonrecourse notes payable and subordinated notes as of December 31, 1999, mature as follows:
The Company estimates that the fair value of its borrowings approximates the carrying value based on terms currently available.
5. INCOME TAXES
The following summarizes the components of deferred income taxes included in the Company's consolidated balance sheets at December 31:
Net operating loss carryforwards of approximately $6,100,000 will be an available deduction from future taxable income, expiring approximately 45% in 2010 and prior, and approximately 55% in 2018 and after. Realization of the net operating loss carryforwards is dependent on generating sufficient taxable income prior to expiration of the loss carryforward. Although realization is not assured, the Company believes it is more likely than not that all of the deferred tax asset will be realized and therefore no valuation allowance is deemed necessary.
The provision (benefit) for income taxes is comprised as follows:
The difference between the normal federal statutory tax rate of 34% applied to income before income taxes and the Company's effective tax rate is:
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. STOCKHOLDERS' EQUITY
STOCK OPTION PLAN. The Company established the 1993 Stock Option Plan (the Plan) to encourage stock ownership by employees, officers, directors and other individuals as determined by the Board of Directors or a committee appointed by the Board of Directors (the Committee). The Plan provides that options granted thereunder may be either incentive stock options (ISOs) or nonqualified stock options. At December 31, 1999, the maximum number of shares of common stock available for grant under the Plan was 1,350,000.
Options may have a maximum term of up to ten years. The exercise price of ISOs granted under the Plan must be at least equal to the fair value of the common stock on the date of grant. The exercise price of nonqualified options must be at least equal to 85% of the fair value of the common stock on the date of grant. If an option expires, terminates or is canceled, the shares not purchased thereunder become available for additional option awards under the Plan. The Plan expires on April 1, 2003. Newly elected non-employee directors of the Company receive an initial grant of non-qualified options to purchase 5,000 shares of common stock upon election to the Board.
Option activity is summarized as follows:
The following table summarizes stock options outstanding at December 31, 1999:
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. STOCKHOLDERS' EQUITY (CONTINUED)
At December 31, 1999, the range of exercise prices and weighted average remaining contractual life of outstanding options was $1.50 - $10.05, and 7.0 years, respectively. Had the Company used the fair value-based method of accounting and recognized compensation expense over the vesting period as provided for in Financial Accounting Standards Board Statement No. 123, STOCK BASED COMPENSATION, net income and net income per share for 1999, 1998 and 1997 would have been as follows:
The pro forma information above only includes stock options granted after December 31, 1994. Pro forma compensation expense under the fair value-based method of accounting will generally increase over the next few years as additional stock option grants are considered.
The weighted-average grant-date fair value of options granted was $0.86, $2.57, and $2.35 per option for 1999, 1998 and 1997, respectively. The weighted-average grant-date fair value of options was determined by using the fair value of each option grant on the date of grant, utilizing the "Black-Scholes" option-pricing model and the following key assumptions:
PREFERRED STOCK. The Company's Articles of Incorporation, as amended, authorize the issuance of 2,000,000 shares of preferred stock, par value $0.01 per share. The rights, preferences and privileges of the authorized preferred shares (none of which have been issued) may be established by the Board of Directors without further action by the holders of the Company's common stock.
WARRANTS. In June 1999, the Company issued a warrant to purchase approximately 5% of the Company's common stock, or 184,000 shares of common stock to DigiDeal Corporation ("DigiDeal") as part of its purchase of certain intellectual property rights from DigiDeal covered by an agreement for technology transfer, manufacture, distribution and affecting patent trademark and copyrights (the Technology Agreement). These warrants have an exercise price of $3.75 per share, expire in 2004 and are exercisable only upon the achievement of certain levels of revenues from Designated Products, as defined. An additional warrant was granted to DigiDeal Corporation for the right to purchase an additional 184,000 shares of common stock of the Company once revenues from Designated Products reach certain levels (2.5% upon achievement of each of two goals). The Company valued these warrants at a total of $500,000, which was treated as an asset, with a corresponding entry to additional paid in capital, and will be amortized over the life of the Technology Agreement. The Company has reciprocal rights to purchase up to 10% of the common shares of DigiDeal at $1.35 per share.
In 1998, the Company issued 690,000 detachable stock purchase warrants as part of the Subordinated Notes offering. These warrants have an exercise price of $12.25 per share and expire in 2003, are exercisable beginning on May 4,1999. The Company also issued a warrant to purchase 50,000 shares of common stock to the underwriter for the Subordinated Notes offering, and such warrants have the same terms as the warrants described in the preceding sentence, except that such warrants are exercisable beginning on May 4, 2000. The Company valued these warrants at a total of $740,000, of which $690,000 was treated as a debt discount, and $50,000 as deferred debt issue costs, with a corresponding entry to additional paid in capital. Also in 1998, the Company issued warrants to purchase 181,700 shares of common stock to a financial institution in partial consideration for the approval of a $25 million revolving line of credit. These warrants have an exercise price of $4.66 per share, expire in 2003 and were exercisable as of October 1998.
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. STOCKHOLDERS' EQUITY (CONTINUED)
The Company valued these warrants at a total of $363,400, which was treated as deferred debt issue costs, with a corresponding entry to additional paid in capital.
In 1994, the Company issued warrants (the "IPO Warrants") to purchase up to 170,000 shares of its common stock to the underwriter in connection with the initial public offering of its common stock and a certain lender in connection with bridge note financing. The warrants are exercisable into common stock at $6.00 per share had a cash-less exercise provision and expired in 1999. During 1998, a total of 121,500 warrants were surrendered to the Company resulting in proceeds to the Company of $15,000 and issuance of approximately 45,700 shares of common stock. There were no warrants surrendered in 1999.
7. EMPLOYEE MATTERS
BENEFIT PLANS. The Company maintains a contributory defined contribution plan that qualifies under Section 401(k) of the Internal Revenue Code (IRC) and covers eligible employees. Company contributions are at the discretion of the Board of Directors up to 5% of the individual employee earnings. The Company's contributions to the plan in 1999, 1998 and 1997 were not material.
EMPLOYMENT AGREEMENTS. The Company has entered into employment agreements with its three officers for periods ranging from one to five years. Each of the agreements contain noncompete clauses which continue from one to two years following termination of employment. The agreements, among other things, provide for initial base salaries, benefits and payment of both performance and discretionary bonuses. The agreements are automatically extended for additional one-year periods unless notice of nonextension is given.
8. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT
During 1999, no customer accounted for more than 10% of revenues. During 1998, three customers accounted for 20%, 19%, and 16% of revenue, respectively, and in 1997, one of these customers and two others accounted for 37%, 18%, and 11% of revenues, respectively.
During 1999, one customer accounted for 54% of fee income. During 1998 and 1997, no customer accounted for more than 10% of fee income.
As of December 31, 1999, the Company's five largest customers represented 11%, 8%, 6%, 6%, and 4% of the total note and lease portfolio of $84,601,000. No other customer represented more than 2% of the note and lease portfolio.
Based on the carrying value of the underlying notes and leases, 97% of the Company's portfolio is located in the United States, with 60%, 14%, and 13% in the states of Nevada, Colorado, and Mississippi.
9. COMMITMENTS AND CONTINGENCIES:
The Company leases office and space for its reconditioning activities under terms of various noncancelable operating leases expiring through 2004. The lease agreements require the Company to pay monthly base rent in varying amounts plus its pro rata share of the operating expenses. Rent expense was approximately $494,000, $470,000 and $305,000 in 1999, 1998, and 1997.
Future minimum lease payments under these leases are as follows:
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. SEGMENT INFORMATION:
The Company conducts business with external customers through the operations of its PDS Slot Source ("Slot Source") and PDS Finance ("Finance") segments. In addition, employees of the Company provide certain legal, accounting and compliance, personnel and other administrative support services on behalf of Slot Source and Finance. The costs associated with these activities (SG & A) are not separately allocated to each business unit. Prior to 1999, the activities of Slot Source and Finance were conducted as one reporting segment.
The accounting policies of each business unit are the same as those described in Note 1 of Notes to Consolidated Financial Statements. The Company evaluates the performance of its operating segments based on earnings before income taxes. Financial performance measurements for Slot Source, Finance, and SG & A are set forth below for the year ended December 31, 1999.
11. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments was made in accordance with Statements of Financial Standards No. 107 ("SFAS No. 107"), Disclosures about Fair Value of Financial Instruments. SFAS No. 107 specifically excludes certain items from its disclosure requirements such as the company's investment in equipment under operating lease, net, and equipment held for sale or lease. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the net assets of the Company
The carrying amounts at December 31, 1999 for cash and cash equivalents, notes, accounts, and leases receivable, net equipment purchases payable, accounts payable notes payable and subordinated debt approximate their fair values due to the short maturity of these instruments, or because the related interest rates approximate current market rates.
12. SUPPLEMENTAL CASH FLOW INFORMATION:
PDS FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. SUPPLEMENTAL CASH FLOW INFORMATION (CONTINUED):
13. SUBSEQUENT EVENT
On March 6, 2000, the Company signed a non-binding letter of intent with Elsinore Corporation to acquire the capital stock of Four Queens, Inc., a Nevada corporation doing business as the Four Queens Hotel & Casino for a purchase price of $30 million, subject to adjustment. Consummation of the acquisition is subject to a number of conditions, including negotiation and approvals, including approval of the Nevada Gaming Commission, other gaming approvals, and, if necessary, approval under the Hart-Scott-Rodino Antitrust Act, and receipt by the Company of satisfactory purchase financing. There can be no assurance that a definitive agreement can be reached, the other conditions to the acquisition will be satisfied or that the acquisition will be consummated.
14. QUARTERLY RESULTS (UNAUDITED)
The following table sets forth selected historical operating results for each quarter of 1999 and 1998. The quarterly information is unaudited but, in management's opinion, reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the periods presented:
The summation of quarterly per share amounts may not equal the calculation for the full year, as each quarterly calculation is performed discretely.