UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
		SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2006 OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
		SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from       to

Commission File Number 0-4281

BALLY TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)

 

Registrant’s telephone number: (702) 584-7700

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  o Yes    x No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.   
See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  x No

The number of shares of Common Stock, $0.10 par value, outstanding as of June 15, 2007, according to the records of the registrant’s registrar and transfer agent was 53,972,000 which does not include 587,000 shares held in treasury.

EXPLANATORY NOTE

As previously disclosed on the Form 12b-25 of Bally Technologies, Inc. (“Bally,” the “Company,” or “we”), filed with the Securities and Exchange Commission (the “SEC”) on February 12, 2007, the filing of this Quarterly Report on Form 10-Q for the quarter ended December 31, 2006 was originally delayed due to the significant amount of additional time and resources necessary to complete our amended and restated Annual Report on Form 10-K for the fiscal year ended June 30, 2005 (the “2005 10-K/A”), which was filed with the SEC on October 31, 2006.  The filing of this Quarterly Report on Form 10-Q was further delayed by the significant amount of time and resources necessary to complete our Quarterly Reports on Form 10-Q for the quarters ended September 30, 2005, December 31, 2005 and March 31, 2006, as well as our Annual Report on Form 10-K for the fiscal year ended June 30, 2006 (the “2006 10-K”), which was filed with the SEC on March 15, 2007. Furthermore, the preparation of the financial information presented in this Quarterly Report on Form 10-Q required additional time and resources because it was prepared while certain material weaknesses existed in our internal control over financial reporting.

I N D E X

PART I.		FINANCIAL INFORMATION
Item 1.		Financial Statements
		Unaudited Condensed Consolidated Balance Sheets as of December 31, 2006 and June 30, 2006
		Unaudited Condensed Consolidated Statements of Operations for the Three Months and Six Months Ended December 31, 2006 and 2005
		Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended December 31, 2006 and 2005
		Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures About Market Risk
Item 4.		Controls and Procedures
PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings
Item 1A.		Risk Factors
Item 6.		Exhibits
SIGNATURES

 

PART I

BALLY TECHNOLOGIES, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

		December 31,			June 30,
		2006			2006
		(in 000s, except share amounts)
ASSETS
Current assets:
Cash and cash equivalents		$	12,432		$	16,425
Restricted cash		15,687			14,484
Accounts and notes receivable, net of allowances for doubtful accounts of $7,478 and $8,073		136,735			135,497
Inventories		70,281			69,995
Income taxes receivable		570			266
Deferred tax assets, net		51,374			51,374
Other current assets		42,708			41,313
Total current assets		329,787			329,354
Long-term investments (restricted)		10,373			8,984
Long-term receivables		5,473			6,436
Property, plant and equipment, net of accumulated depreciation of $48,106 and $49,756		78,635			68,464
Leased gaming equipment, net of accumulated depreciation of $73,081 and $64,160		56,773			43,408
Goodwill		161,590			161,303
Intangible assets, net of accumulated amortization of $25,971 and $23,963		24,873			27,656
Deferred tax assets, net		22,112			20,048
Other assets, net		29,101			22,228
Total assets		$	718,717		$	687,881
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	34,379		$	39,622
Accrued liabilities		74,375			86,131
Jackpot liabilities		13,388			13,139
Deferred revenue		63,453			47,081
Current maturities of long-term debt and capital leases, including $5,219 and $6,600 owed to related parties		16,066			12,864
Total current liabilities		201,661			198,837
Long-term debt and capital leases, net of current maturities, including $8,981 and $7,600 owed to related parties		328,115			315,482
Other liabilities		33,859			28,800
Total liabilities		563,635			543,119
Minority interest		1,554			684
Commitment and Contingencies (Note 9)
Stockholders’ equity:
Special stock, 10,000,000 shares authorized: Series E, $100 liquidation value; 115 shares issued and outstanding		12			12
Common stock, $.10 par value; 100,000,000 shares authorized; 53,741,000 and 52,880,000 shares issued and 53,210,000 and 52,354,000 outstanding		5,368			5,283
Treasury stock at cost, 531,000 and 526,000 shares		(706		)	(665		)
Additional paid-in capital		231,851			219,472
Accumulated other comprehensive income		1,118			1,351
Accumulated deficit		(84,115		)	(81,375		)
Total stockholders’ equity		153,528			144,078
Total liabilities and stockholders’ equity		$	718,717		$	687,881

 

See accompanying notes to unaudited condensed consolidated financial statements.

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BALLY TECHNOLOGIES, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

		Three Months Ended						Six Months Ended
		December 31,						December 31,
		2006			2005			2006			2005
		(in 000s, except per share amounts)
Revenues:
Gaming equipment and systems		$	140,533		$	113,961		$	282,496		$	208,756
Casino operations		11,238			13,513			23,077			24,158
		151,771			127,474			305,573			232,914
Costs and expenses:
Cost of gaming equipment and systems		70,653			65,266			143,540			114,163
Cost of casino operations		4,439			4,939			8,901			9,222
Selling, general and administrative		51,622			46,028			101,666			86,960
Research and development costs		13,307			10,785			25,863			21,042
Depreciation and amortization		5,903			6,951			11,336			12,824
		145,924			133,969			291,306			244,211
Operating income (loss)		5,847			(6,495		)	14,267			(11,297		)
Other income (expense):
Interest income		413			589			1,324			1,492
Interest expense		(10,200)			(7,272		)	(18,121		)	(13,204		)
Other, net		675			(250		)	925			(521		)
Loss before income taxes and minority interest		(3,265		)	(13,428		)	(1,605		)	(23,530		)
Income tax benefit		2,358			4,702			1,687			8,835
Minority interest		(1,608		)	(177		)	(2,822		)	(2,587		)
Net loss		$	(2,515	)	$	(8,903	)	$	(2,740	)	$	(17,282	)
Basic and diluted loss per share		$	(0.05	)	$	(0.17	)	$	(0.05	)	$	(0.33	)
Weighted average shares outstanding:
Basic and diluted		53,072			52,138			52,985			52,138

 

See accompanying notes to unaudited condensed consolidated financial statements.

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BALLY TECHNOLOGIES, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

		Six Months Ended December 31,
		2006			2005
		(in 000s)
Cash flows from operating activities:
Net loss		$	(2,740	)	$	(17,282	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		29,330			30,938
Share-based compensation		8,112			5,914
Deferred income taxes		(2,063		)	(9,012		)
Provision for doubtful accounts		290			680
Inventory and other asset write-downs		6,215			7,983
Other		9,523			6,960
Changes in operating assets and liabilities:
Accounts and notes receivable		(1,036		)	(23,809		)
Inventories		(10,719		)	4,446
Other current assets		(785		)	3,656
Accounts payable		(6,759		)	(8,847		)
Accrued liabilities, deferred revenue and jackpot liabilities		2,901			21,540
Net cash provided by operating activities		32,269			23,167
Cash flows from investing activities:
Additions to property, plant, and equipment		(8,778		)	(6,246		)
Additions to leased gaming equipment		(47,486		)	(19,933		)
Restricted cash and investments		(1,138		)	(866		)
Additions to other long-term assets		(1,251		)	(1,804		)
Net cash used in investing activities		(58,653		)	(28,849		)
Cash flows from financing activities:
Proceeds from revolving credit facility		5,000			—
Payments on revolving credit facility		(5,000		)	—
Reduction of long-term debt		(4,224		)	(3,042		)
Proceeds from sale lease-back arrangements		22,303			—
Proceeds from exercise of stock options		4,311			172
Net cash provided by (used in) financing activities		22,390			(2,870		)
Effect of exchange rate changes on cash		1			23
Cash and cash equivalents:
Decrease for period		(3,993		)	(8,529		)
Balance, beginning of period		16,425			33,170
Balance, end of period		$	12,432		$	24,641

 

See accompanying notes to unaudited condensed consolidated financial statements.

4

BALLY TECHNOLOGIES, INC.
FORM 10-Q
Notes to Unaudited Condensed Consolidated Financial Statements

1.             BASIS OF PRESENTATION

Principles of presentation and consolidation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and reflect all adjustments, consisting of normal recurring adjustments, which management believes are necessary to fairly present the financial position, results of operations and cash flows of Bally Technologies, Inc., a Nevada corporation, and its subsidiaries (“Bally” or the “Company”) for the respective periods presented.  The results of operations for an interim period are not necessarily indicative of the results that may be expected for any other interim period or the year as a whole. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006 as filed with the SEC on March 15, 2007.

Bally is a diversified, worldwide gaming company that designs, manufactures, distributes and operates gaming machines and computerized monitoring systems for gaming machines and owns and operates one casino.

The Company is the general partner of Rainbow Casino Vicksburg Partnership (“RCVP”), which operates the Rainbow Casino in Vicksburg, Mississippi.  Pursuant to transactions consummated in March 1995, the Rainbow Corporation, which was the former general partner of RCVP, became a limited partner entitled to receive 10% of the net available cash flows of RCVP after debt service and other items, as defined in the limited partnership agreement, which increases to 20% of the incremental amount of revenues in excess of $35.0 million, payable quarterly through December 31, 2010.  The Company holds the remaining economic interest in the partnership.  The Company announced in October 2006 that it is evaluating alternatives with respect to the possible sale of the Rainbow Casino.  The Company consolidates RCVP and records an adjustment to reflect the portion of the earnings of RCVP attributable to the minority shareholders.  As of September 30, 2006, RCVP did not meet the requirements for classification as an asset held for sale or discontinued operations.

The Company also consolidates certain Atlantic City progressive trusts in accordance with Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) 46R, Consolidation of Variable Interest Entities, which addresses consolidation by a business enterprise of variable interest entities (“VIE’s”) that either: (1) do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support or (2) hold a significant variable interest in, or have significant involvement with, an existing VIE.  As of December 31, 2006 and June 30, 2006, the Company consolidated $6.2 million and $4.7 million, respectively, in total assets and liabilities, primarily consisting of restricted cash accounts and restricted investments (included in other assets in the condensed consolidated balance sheets) and related jackpot liabilities.  The following revenues and costs were also consolidated:

		Three Months Ended December 31,						Six Months Ended December 31,
		2006			2005			2006			2005
		(in 000s)
Gaming equipment and systems revenue		$	1,655		$	1,717		$	4,001		$	4,337
Cost of gaming equipment and systems		322			2,335			1,806			3,273

 

All intercompany accounts and transactions have been eliminated in consolidation.

Reclassifications

Pursuant to Emerging Issues Task Force (EITF) Issue No. 00-22, Accounting for “Points” and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future, and EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products), the Company has concluded that certain promotional expenses, representing coupons redeemable for cash incentives, should be presented as an offset against casino operations revenue. Accordingly, we have reclassified $1.0 million and $1.9 million, respectively, for the three and six months ended December 31, 2005,

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from selling, general and administrative expense as an offset against casino operations revenue to conform to the current period presentation.

Inventories

Inventories are stated at the lower of cost, determined on a first in, first out basis, or market.  Cost elements included in work-in-process and finished goods include raw materials, freight, direct labor and manufacturing overhead.

The Company recorded inventory write-downs totaling approximately $1.8 million and $4.1 million and $6.2 million and $8.0 million for the three and six months ended December 31, 2006 and 2005, respectively.  These charges are classified in cost of gaming equipment and systems in the consolidated statements of operations.

Property, plant and equipment and leased gaming equipment

Property, plant and equipment is stated at cost and depreciated over the estimated useful lives or lease term, if less, using the straight line method as follows: buildings and improvements, 28 to 40 years; gaming equipment, 4 to 7 years; furniture, fixtures and equipment, 3 to 7 years; and leasehold improvements, 5 to 10 years. Leased gaming equipment is stated at cost and depreciated over the estimated useful lives ranging from 2 to 3½ years.

Recently Issued Accounting Pronouncements

In February 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No.159 provides companies with an option to report selected financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements to facilitate comparisons between companies using different measurement attributes for similar types of assets and liabilities. The statement is effective for fiscal years beginning after November 15, 2007, and accordingly, the Company expects to adopt SFAS No. 159 beginning in fiscal 2009. Earlier application is permitted provided the Company also applies the provisions of SFAS No. 157, Fair Value Measurements. The Company is currently in the process of evaluating the impact SFAS No. 159 will have on its consolidated results of operations, financial position and cash flows.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, rather it applies to existing accounting pronouncements that require or permit fair value measurements.  SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and accordingly, the Company expects to adopt SFAS No. 157 beginning in fiscal 2009. The Company is currently in the process of evaluating the impact SFAS No. 157 will have on its consolidated results of operations, financial position and cash flows.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, providing guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year's financial statements are materially misstated. The provisions of SAB No. 108 were effective beginning with the Company’s fiscal year ending June 30, 2007.  The adoption SAB No. 108 did not have a material impact on the Company’s consolidated results of operations, financial position or cash flows.

In July 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes, which creates a single model to address uncertainty in income tax positions and prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, and accordingly, the Company expects to adopt FIN 48 beginning in fiscal 2008. The Company is currently in the process of evaluating the impact FIN 48 will have on its consolidated results of operations, financial position and cash flows.

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2.             EARNINGS (LOSS) PER SHARE

The computation of basic and diluted loss per share applicable to the Company’s common stock is as follows:

		Three Months Ended December 31,						Six Months Ended December 31,
		2006			2005			2006			2005
		(in 000s, except per share amounts)
Net loss		$	(2,515	)	$	(8,903	)	$	(2,740	)	$	(17,282	)
Weighted average common shares outstanding:
Basic and diluted		53,072			52,138			52,985			52,138
Basic and dilutive loss per share		$	(0.05	)	$	(0.17	)	$	(0.05	)	$	(0.33	)

 

For the three and six month periods ended December 31, 2006 and 2005, all potentially dilutive securities were excluded from the diluted per share calculation as their inclusion would have been anti-dilutive due to the net loss reported.  Such securities consist of the following:

		Three Months Ended December 31,				Six Months Ended December 31,
		2006		2005		2006		2005
		(in 000s)
Stock options		8,980		9,111		8,721		8,952
Warrants		100		100		100		100
Restricted stock		621		554		593		554
Total		9,701		9,765		9,414		9,606

 

As of December 31, 2006 and 2005, the Company also had certain related party debt outstanding which is convertible into common stock at the Company’s discretion.  The potential dilution from this convertible debt has not been included in the diluted loss per share computation for the three and six months ended December 31, 2006 and 2005, due to the reported net loss for the periods.  Assuming the conversion occurred on December 31, 2006 and 2005, an additional 0.6 million and 1.1 million shares, respectively, would have been outstanding as a result of the conversion.

3.             SHARE-BASED COMPENSATION

In December 2001, the Company’s shareholders approved the 2001 Long-Term Incentive Plan (as amended, the “2001 Plan”). The 2001 Plan provides for the issuance of up to 10,550,000 shares of common stock to Company employees, directors and designated paid consultants, which amount consists of up to 900,000 shares of restricted stock or Restricted Stock Units (“RSUs”). Generally, options are granted at the fair value of the Company’s common stock at the date of grant and are exercisable over ten years.

Effective July 1, 2005, the Company adopted the provisions of SFAS No. 123R, Share-Based Payment, which established accounting for equity instruments exchanged for employee services. SFAS No. 123R requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by the Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees.  Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant).  In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, Share-Based Payment, which provided interpretive guidance on SFAS No. 123R valuation methods, assumptions used in valuation models, and the interaction of SFAS No. 123R with existing SEC guidance. SAB No. 107 also requires the classification of share-based compensation expense in the same financial statement line as cash compensation, and therefore, impacted the Company’s cost of gaming equipment and systems, casino operations

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(and related gross profits and margins), research and development costs, and selling, general and administrative expenses.

The following table presents share-based compensation expense included in the Company’s condensed consolidated statements of operations:

		Three Months Ended December 31						Six Months Ended December 31
		2006			2005			2006			2005
		(in 000s)
Selling, general and administrative		$	3,931		$	2,882		$	7,277		$	5,372
Research and development		392			265			767			496
Cost of gaming and equipment		37			25			68			46
Share-based compensation expense before tax		4,360			3,172			8,112			5,914
Income tax benefit		1,526			1,110			2,839			2,069
Net share-based compensation expense		$	2,834		$	2,062		$	5,273		$	3,845

 

As of December 31, 2006, there was $26.8 million of total unrecognized compensation expense related to the unvested portion of stock options which will be recognized over the next four years.

The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s common stock over the option’s expected term, the risk-free interest rate over the option’s expected term and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards.

The fair value of each option granted during the periods referenced below was estimated on the grant date using the Black-Scholes valuation model with the following assumptions:

		Three Months Ended December 31,				Six Months Ended December 31,
		2006		2005		2006		2005
Weighted Average:
Expected option term (in years)		6.14		6.25		6.18		6.37
Expected volatility		56.82	%	61.56	%	57.41	%	62.01	%
Risk-free interest rate		4.70	%	4.18	%	4.76	%	3.74	%
Expected annual dividend yield		—		—		—		—

 

Stock option activity as of and for the six months ended December 31, 2006 is summarized below:

		Weighted Average
		Shares		Exercise Price			Remaining Contractual Term		Aggregate Intrinsic Value
		(in 000s)		(per share)			(years)		(in 000s)
Balance outstanding as of June 30, 2006		9,640		$	14.61		6.41		$	32,290
Granted		882		18.30
Exercised		(756	)	5.75
Forfeited or expired		(581	)	15.48
Balance outstanding as of December 31, 2006		9,185		$	15.63		6.54		$	37,386
Exercisable as of December 31, 2006		5,286		$	16.92		5.40		$	18,306

 

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Restricted stock and RSU activity as of and for the six months ended December 31, 2006 is summarized below:

				Weighted Average
		Shares		Grant Date Fair Value
		(in 000s)		(per share)
Balance outstanding as of June 30, 2006		647		$	15.51
Granted		84		16.37
Forfeited or expired		(2	)	17.00
Balance outstanding as of December 31, 2006		729		$	15.61
Vested as of December 31, 2006		342		$	15.90

 

4.             GOODWILL AND INTANGIBLE ASSETS

Finite lived intangible assets

Substantially all of the Company’s recorded intangible assets are subject to amortization.  Finite lived intangible assets are comprised of the following: 

		December 31, 2006			June 30, 2006
		(in 000s)
Amortizable intangible assets:
Patents and gaming related products		$	20,434		$	19,583
Less: accumulated amortization		(8,401		)	(7,061		)
		12,033			12,522
Licenses and other		$	30,410		$	32,036
Less: accumulated amortization		(17,570		)	(16,902		)
		12,840			15,134
Total		$	24,873		$	27,656

 

Goodwill

The changes in the carrying amount of goodwill for the six month period ended December 31, 2006, are as follows:

 

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5.             LONG-TERM DEBT AND CAPITAL LEASES

Long-term debt and capital leases consist of the following:

		December 31, 2006			June 30, 2006
		(in 000s)
Revolving credit facility		$	—		$	—
Term loan facility		309,632			311,382
Capital lease obligations		20,325			2,399
Related party debt (see Note 6)		14,200			14,200
Other, generally unsecured		24			365
Long-term debt and capital leases		344,181			328,346
Less current maturities		16,066			12,864
Long-term debt and capital leases, less current maturities		$	328,115		$	315,482

 

The Company’s debt structure at December 31, 2006 consists primarily of a term loan facility and a $75.0 million revolving credit facility, which are limited by a current leverage ratio and debt owed to related parties. The term loan requires principal reductions of approximately 1% per annum paid quarterly, with a balloon payment due in September 2009.  The revolving credit facility commitment reduces annually until it comes due in September 2008.  As of December 31, 2006, the term loan had an interest rate of 8.83%, based on LIBOR plus 3.25%, and the revolving credit facility had an interest rate of 7.87%, based on LIBOR plus 2.50%. On January 4, 2007, the Company initiated its next LIBOR-based term loan interest rate period (for a term of six months) based on the interest rate formula of LIBOR plus 3.25%,  which was 8.61%.

The term loan and the revolving credit facility are collateralized by substantially all of the Company’s domestic property and are guaranteed by each of the Company’s domestic subsidiaries, other than the entity that holds the Company’s interest in its Rainbow Casino operations, and are secured by a pledge agreement. The loan agreement governing the term loan and the revolving credit facility (the “Loan Agreement”) contains a number of maintenance and other covenants that, among other things, restrict the ability of the Company and the ability of certain of its subsidiaries to dispose of assets, incur additional indebtedness or issue preferred stock, pay dividends or make other distributions, enter into certain acquisitions, repurchase equity interests or subordinated indebtedness, issue or sell equity interests of the Company’s subsidiaries, engage in mergers or acquisitions or certain transactions with subsidiaries and affiliates, and that otherwise restrict corporate activities.  The Company was in compliance with these covenants as of December 31, 2006.

As of December 31, 2006, the Company was also in compliance with its financial covenants consisting of a leverage ratio, a fixed charges coverage ratio and a minimum of Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) (as EBITDA is defined in the Loan Agreement). The leverage ratio is computed as total average debt outstanding during the quarter divided by the trailing 12 months EBITDA, excluding certain cash and non-cash charges. The Company’s leverage ratio as of December 31, 2006 was 3.36 times versus a maximum allowable of 3.75 times. The maximum allowable leverage ratio declines to 3.50 as of September 30, 2007, through the remaining term of the Loan Agreement.

In October 2006, the Company executed an amendment to the Loan Agreement, which, among other things, (i) extended the due date for the  delivery of the Company’s audited financial statements for the fiscal year ended June 30, 2006 to December 31, 2006, (ii) provided that the Company deliver its quarterly reports on Form 10-Q for the Fiscal Quarters ended September 30, 2005, December 31, 2005 and March 31, 2006 no later than December 31, 2006, (iii) modified the definition of EBITDA to exclude up to $10.0 million of certain cash charges and (iv) clarified that the definition of EBITDA includes interest income on trade receivables.  In exchange for the concessions granted under the amendment the Company paid an administrative fee of $964,000, which was expensed in the quarter ended December 31, 2006.

In December 2006, the Company executed an additional amendment to the Loan Agreement, which extended the due date for the  delivery of the Company’s quarterly report on Form 10-Q for the Fiscal Quarter ended March 31, 2006 and its audited financial statements for the fiscal year ended June 30, 2006 to March 15, 2007.  In exchange for the concessions granted under the amendment the Company paid an administrative fee of $1.2 million, which was expensed in the quarter ended December 31, 2006.

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Capital lease obligations represent amounts owed under lease or sale-lease back transactions primarily related to equipment used in the Company’s Gaming Equipment and Systems segment.  The leases are payable in thirty-six equal installments with interest imputed at a weighted average rate of 9.12%.

The Company’s related party debt, which totaled approximately $14.2 million as of December 31, 2006, consists primarily of the debt owed to the former principals of Sierra Design Group (“SDG”) and MindPlay LLC (“MindPlay”). See Note 6, Related Party Transactions, below regarding related party debt.

6.             RELATED PARTY TRANSACTIONS

The Company completed the acquisition of all of the assets of SDG during fiscal 2005 and substantially all of the assets and liabilities of MindPlay during fiscal 2004.  In each acquisition, a portion of the consideration included subordinated debt issued to the former principals of each business.  Certain of the former principals are now employees of the Company, and therefore, such debt is considered to be owed to related parties.  The interest rates on the outstanding debt range from a variable rate of LIBOR plus 2% to a fixed rate of 6%.  The following table presents the outstanding related party debt and interest rates as of the period referenced:

 

		December 31, 2006					June 30, 2006
		Interest  Rate		Outstanding Debt			Interest Rate		Outstanding  Debt
		(in 000s)
SDG		6.39	%	$	11,200		6.39	%	$	11,200
MindPlay		6.00	%	3,000			6.00	%	3,000
Related party debt				14,200					14,200
Less current maturities				5,219					6,600
Related party debt, less current maturities				$	8,981				$	7,600

 

The note payable to the former principals of SDG of $11.2 million is payable in annual installments through 2009.  At the Company’s discretion, the principal and accrued interest thereon can be paid in cash, or can be converted into shares of the Company’s common stock using the average stock price for the 20 business days prior to the delivery of such shares.

In February 2004, the Company acquired substantially all of the assets and liabilities of MindPlay.  The initial purchase price included, among other things, the issuance of a $4.0 million note payable.  As provided for in the acquisition agreement, under certain circumstances, the Company may offset 50% of all damages (including reasonable attorneys’ fees) up to the entire amount due under the promissory note in connection with an indemnification claim against the former shareholders of MindPlay related to the Company’s patent lawsuit with Shuffle Master, Inc. (“Shuffle Master”) and International Game Technology (“IGT”) which is described below in Note 9, Commitments and Contingencies.

The Company leases a warehouse and office facility from an entity owned by Mr. Robert Luciano, a former principal of SDG and the Company’s Chief Technology Officer.  Rental payments totaled $112,041 and $103,000 and $224,082 and $206,000 for the three and six month periods ended December 31, 2006 and 2005, respectively.

7.             SEGMENTS AND GEOGRAPHICAL INFORMATION

The Company operates in two business segments: (i) Bally Gaming Equipment and Systems which designs, manufactures, assembles, distributes and operates gaming machines and computerized monitoring and bonusing systems for gaming machines, and (ii) Casino Operations which owns and operates a casino in Vicksburg, Mississippi. The accounting policies of these segments are consistent with the Company’s policies for the unaudited condensed consolidated financial statements.

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The table below presents information as to the Company’s revenues and operating income (loss) by segment:

		Three Months Ended December 31,						Six Months Ended December 31,
		2006			2005			2006			2005
		(in 000s)
Revenues:
Gaming Equipment and Systems		$	140,533		$	113,961		$	282,496		$	208,756
Casino Operations		11,238			13,513			23,077			24,158
Total revenues		$	151,771		$	127,474		$	305,573		$	232,914
Inter-segment revenues:
Gaming Equipment and Systems		$	102		$	214		$	184		$	303
Casino Operations		—			—			—			—
Total inter-segment revenues		$	102		$	214		$	184		$	303
Operating income (loss):
Gaming Equipment and Systems		$	9,076		$	(4,817	)	$	20,110		$	(6,245	)
Casino Operations		3,933			5,107			7,968			8,428
Corporate/other		(7,162		)	(6,785		)	(13,811		)	(13,480		)
Total operating income (loss)		$	5,847		$	(6,495	)	$	14,267		$	(11,297	)

 

The Company’s operations are based primarily in the United States with sales and distribution offices in Europe and South America.

The table below presents information as to the Company’s revenues and operating income (loss) by geographic region:

		Three Months Ended December 31,						Six Months Ended December 31,
		2006			2005			2006			2005
		(in 000s)
Revenues:
United States		$	141,294		$	119,193		$	286,514		$	219,388
Europe		5,232			4,749			8,715			8,204
Other foreign		5,245			3,532			10,344			5,322
Total revenues		$	151,771		$	127,474		$	305,573		$	232,914
Operating income (loss):
United States		$	5,223		$	(6,028	)	$	13,217		$	(10,383	)
Europe		89			(643		)	(360		)	(1,195		)
Other foreign		535			176			1,410			281
Total operating income (loss)		$	5,847		$	(6,495	)	$	14,267		$	(11,297	)

 

 

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8.             SUPPLEMENTAL CASH FLOW INFORMATION

The following supplemental information is related to the condensed consolidated statements of cash flows:

		Six Months Ended December 31,
		2006			2005
		(in 000s)
Cash paid for interest		$	16,809		$	14,041
Cash paid for income taxes		683			2,289
Non-cash investing and financing transactions:
Reclassify property, plant and equipment to inventory		$	6,388		$	7,891
Inventory in transit		1,145			—
Assets acquired through sale lease-back transactions		11,681			—
Unrealized gain on sale lease-back transactions		3,333			—
Receipt of Company’s common stock as consideration for employee stock options exercise		41			—
Consolidation of variable interest entities		1,539			313

 

9.             COMMITMENTS AND CONTINGENCIES

In June and July 2004, putative class actions were filed against the Company and its officers, Robert Miodunski, Robert Saxton, Mark Lerner and Steven Des Champs, in the United States District Court for the District of Nevada. The nearly identical complaints alleged violations of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), stemming from revised earnings guidance, declines in the stock price and sales of stock by insiders. The complaints sought damages in unspecified amounts. The Federal District Court granted the plaintiffs’ unopposed motions to consolidate the cases and to appoint a lead counsel and a lead plaintiff, and the plaintiffs filed a consolidated complaint, all as is customary in such cases.  The Company and the other defendants moved to dismiss the complaint.  Thereafter, activity in the case was stopped and the parties participated in a mediation process during which the parties agreed on the terms of a settlement. The parties have negotiated and executed settlement documents settling both the consolidated class action and the derivative case discussed below. Under the settlement, which has received preliminary approval from the court, an aggregate of $16.0 million cash, plus certain interest, will be paid to settle the securities class action as well as the derivative litigation as discussed below.  The Company will pay $1.25 million, which was accrued in the Company’s financial statements for the quarter ended December 31, 2005. In addition to certain governance actions the Company has agreed to undertake in connection with the settlement, the Company’s directors and officers insurer will contribute approximately $14.75 million to the settlement.

In July 2004, two derivative lawsuits were filed in Nevada state court against the members of the board of directors and the officers listed above. The Company was named as a nominal defendant in the derivative lawsuits as the claims were purportedly asserted for the benefit of Bally Technologies, Inc. These lawsuits asserted claims for breach of fiduciary duty and waste of corporate assets arising out of the same events as those giving rise to the class actions described above, and sought injunctive relief and damages in unspecified amounts. These two cases were consolidated, and the Company and the other defendants moved to dismiss the case. In February 2005, the state district court granted the defendants’ motion and dismissed the case. The plaintiffs appealed the dismissal to the Nevada Supreme Court, which referred the matter to its settlement conference program. The parties met with a court-appointed settlement judge on December 15, 2005, and agreed to settle the case for $8,000, and on February 2, 2006, the Nevada Supreme Court entered its order formally dismissing the appeal, thereby terminating the case. Although management believes the plaintiffs’ lawsuit and appeal were without merit, it determined that the settlement was in the best interests of the Company.

On March 27, 2006, shortly after the aforementioned derivative suit was dismissed in the Nevada state court, another derivative lawsuit was filed in the United States District Court for the District of Nevada against individual

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defendants Robert Miodunski, Robert Saxton, Steven Des Champs, Mark Lerner, David Robbins, Anthony DiCesare, Joel Kirschbaum, Kevin Verner, Richard Haddrill, Stephen Race, Jacques André and nominal defendant Bally Technologies, Inc.  Based on factual allegations that are similar to those alleged in the federal securities class action complaints and the previous derivative actions that were dismissed by the District Court, the derivative complaint alleges breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and violation of the Sarbanes-Oxley Act of 2002. The parties have reached a settlement agreement as discussed more fully above.

In February 2005, the SEC initiated an informal inquiry and requested documents and information regarding matters related to the allegations in the class actions and similar matters. In August 2005, the SEC notified the Company that its investigation had entered a formal phase, and requested additional information from the Company covering the same general areas that were addressed in the informal inquiry. Management is cooperating fully with the SEC in this matter.

In August 2004, Shuffle Master sued the Company in the United States District Court for the District of Nevada, alleging infringement of various patents in connection with the Company’s MindPlay product line and seeking injunctive relief and damages in an unspecified amount. In June 2005, it was announced that IGT had acquired an interest in the patents at issue in the case, and thereafter, IGT joined the case as a plaintiff.  In December 2005, the District Court issued a ruling construing the claim terms of all the patents in the suit. Management believes the plaintiffs’ lawsuit to be without merit, and the Company is vigorously defending against the lawsuit.

In September 2004, a United States District Court jury in the District of Nevada entered a $7.4 million verdict against the Company in a suit filed by Action Gaming (“AGI”) and IGT. The suit alleged that the multi-hand video poker game deployed by the Company’s former subsidiary, United Coin, infringed the plaintiffs’ patents. The Federal District Court ruled on summary judgment that the game did not infringe the patents. However, the court left to the jury the question whether the use of “autohold,” a specific, optional feature of the game, caused it to infringe under the “doctrine of equivalents,” a doctrine of patent law. The jury determined that the game with the autohold option enabled did infringe under the doctrine of equivalents and awarded damages accordingly. The feature has been disabled on all affected games in the field, and the decision permits continued deployment of the game as long as the autohold feature is not included. The Company appealed the decision to the United States Court of Appeals for the Ninth Circuit and posted a cash bond totaling $7.6 million to stay payment of the judgment and accrued interest pending the appeal.   On July 11, 2006, the federal circuit court of appeals affirmed the district court judgment, denying the appeals for both parties, and thereafter, the judgment was satisfied out of the posted bond.

On December 7, 2004, IGT filed a patent infringement lawsuit against the Company in the United States District Court for the District of Nevada. The complaint asserts that the Company’s wheel-based games, such as Monte CarloÔ, Lucky WheelÔ and Cash For LifeÔ, its games with a reel in the top box, such as Bonus FrenzyÔ, and its iViewÔ products infringe on patents held by IGT, and seeks injunctive relief and damages in unspecified amounts. The Company believes IGT’s claims are without merit and is vigorously defending itself against the lawsuit. As part of its defense, the Company has asserted counterclaims against IGT, including claims that IGT’s patents are invalid, unenforceable and not infringed, as well as several claims that IGT has engaged in anti-competitive conduct in violation of state and federal antitrust laws. By its counterclaims, the Company is seeking damages and other relief from IGT. IGT’s motion to dismiss the Company’s antitrust claims was denied in January 2006, and in March 2007, the court denied IGT’s motions for summary judgment with respect to the antitrust claims dealing with the wheel game market.  The court issued claims construction rulings in May 2007.  No trial date has been set.

In September 2006, the Company filed a patent infringement lawsuit against IGT in the United States District Court for the District of Nevada.  The complaint asserts that certain of IGT’s bonus wheel games infringe patents held by the Company, and seeks injunctive relief and damages.  IGT filed an answer generally denying the claims.  The case is in the discovery phase and no trial date has been set.

In May 2006, IGT filed a patent infringement lawsuit against the Company in the United States District Court for the District of Delaware.  The complaint asserts that the Bally Power BonusingÔ products infringe patents held by IGT, and seeks injunctive relief and damages in unspecified amounts.  The Company believes IGT’s claims are without merit and is

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vigorously defending itself against the lawsuit.

The Company is also a party to various lawsuits relating to routine matters incidental to our business.  Management does not believe that the outcome of such litigation, including the matters above, in the aggregate, will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

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

We begin this Management’s Discussion and Analysis of Financial Condition and Results of Operations with an overview of our key operating business divisions and significant trends as of December 31, 2006.  This overview is followed by a detailed analysis of our results of operations and our financial condition as of, and for, the three and six months ended December 31, 2006.

Forward-Looking Statements

Certain matters in this Quarterly Report on Form 10-Q for the three and six month periods ended December 31, 2006 and our other filings with the SEC, including, without limitation, certain matters discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Quantitative and Qualitative Disclosures about Market Risk, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the safe harbor created thereby.  Those statements reflect the intent, belief or current expectations of the Company, its directors or its officers with respect to, among other things, future events and financial trends affecting the Company.

Forward-looking statements are typically identified by the words “believes,” “expects,” “anticipates” and similar expressions.  In addition, any statements that refer to expectations or other characterizations of future events or circumstances are forward-looking statements.  Readers are cautioned that any such forward-looking statements are not guarantees of future performance and that matters referred to in such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  Such factors include, among other things, the impact of competition and uncertainties concerning such matters as the Company’s ability to service debt, product development, customer financing, sales to non-traditional gaming markets, foreign operations, dependence on key personnel, the ability to integrate future acquisitions, strict regulation by gaming authorities, the outcome of pending litigation matters including the pending securities class actions, gaming taxes, currency fluctuations and market risk and the potential adverse effects to our financial condition, results of operations or prospects as a result of the restatement of our prior period financial statements. Certain of these factors are discussed in the “Risk Factors” contained in the 2006 10-K.  Unless otherwise required by law, the Company undertakes no obligation to publicly update or revise these forward-looking statements because of new information, future events or otherwise.

Our Business

We are a worldwide leader in the design, manufacture, assembly and distribution of technology based products to commercial gaming markets worldwide.  We also own and operate a riverboat, dockside casino in Vicksburg, Mississippi.

We derive our revenues from the following four sources:

·                  Gaming Equipment - Sale of gaming devices;

·                  Gaming Operations - Operation of wide-area progressive systems and the lease and rental of gaming machines;

·                  Systems - Sales of computerized monitoring systems and related recurring hardware and software maintenance revenue; and

·                  Casino Operations - Operation of the Rainbow Casino.

We design, manufacture, assemble, sell and operate a full range of technology based gaming devices through our Gaming Equipment division.  These devices are not mass produced and are normally configured under specific order to a customer’s particular requirements.  Gaming devices are differentiated from one another by a number of factors including, but not limited to, graphic design and theme, cabinet style, pay table, game layout, betting denomination and minimum/maximum betting amount.  Each gaming device typically contains an operating system referred to as a game platform.  The operating system manages the software needed to run the device.  Game platforms and the

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related computer systems are constantly updated and revised to keep pace with the ever-increasing complexity of modern game play requirements.  The constant change in game play requirements is driven by, among other things, changes in consumer demand, capacity, security and regulation.  In fiscal 2005, we completed the successful migration from our legacy platforms, including the V7000 and EVO™, to the Linux-based ALPHA OS™ platform and operating system.  In fiscal 2006, we also extended the transition to the ALPHA OS to our mechanical reel spinning devices.  ALPHA OS is now the platform for each of our gaming device product offerings and, as a result, marketing of our legacy products has generally been discontinued.

The ALPHA OS is designed to separate the gaming operating system from the game layer, which enables game development in a much shorter time.  ALPHA OS is also designed to incorporate bonusing, free spin, scatter and other advanced game features, while providing internal and third-party developers with a secure, easy-to-use programming environment that incorporates an advanced set of development tools.  Moreover, ALPHA OS is designed to support server-based gaming initiatives, including download of game results, configuration and game content. Additionally, our layered architecture and modular design allow for adaptability and simplified requirement changes. The operating system, which is Linux-based, is compatible with the most common accounting and ticket systems and supports 20-plus bet lines, bonusing, multi-denomination and multi-pay table game configurations.  ALPHA OS also supports multi-level local and wide-area progressive products.

In addition to selling our gaming devices, we also offer our customers a wide range of lease and rental options through our Gaming Operations division.  We offer several economic arrangements that generate recurring revenues for us.  Specifically, these arrangements are available under four business models: linked progressive systems, centrally determined systems, lottery systems and rental or leased games.  In most cases, operating gaming devices under a lease or rental arrangement requires us to invest capital in the cost of manufacturing the gaming device and related equipment, purchasing signs and seating, and, in certain cases, acquiring certain intellectual property rights.

We believe the growth of the Gaming Equipment and Gaming Operations divisions is dependent on providing new titles, hardware and technologies with high entertainment value to casino patrons.

We also design, program, test, market and support casino enterprise systems for a wide range of customers of varying size and complexity under our Systems division.  These systems typically provide casino operators features such as active, real-time monitoring tools for gaming devices, tools to collect and manage customer data, security to protect against theft and data loss, and marketing programs to enhance the gaming experience.  The use of system technology in gaming has grown in the past ten years from basic automation of manual activities to highly integrated mission critical applications.  We believe we are the only provider in the industry that offers a selection of technology platform options to its customers.  Our products operate on platforms such as Windows, AS/400 (iSeries) and UNIX that allows our customers to choose a technology solution that meets their existing or future infrastructure requirements.  We market our system product solutions under the broad categories of Bally CMS® (Casino Management Systems), Bally SMS® (Slot Management Systems) and Bally TMS® (Table Management Systems).

We spent approximately 9% of revenue generated from our Bally Gaming Equipment and Systems segment for the six months ended December 31, 2006 on research and development to accelerate the use of technology in our gaming products.

Our Rainbow Casino is one of four casinos currently operating in the Vicksburg, Mississippi market and is run through our Casino Operations division. The facility includes a 33,000-square foot casino with 852 gaming devices and 11 table games, a 310-seat buffet-style restaurant and a 20,000-square foot conference center.  The Casino also includes the 89-room Rainbow Hotel, which is owned and operated by a third party.  Rainbow is marketed as a “locals” casino and draws mid-level gaming customers principally from within a 75-mile radius of Vicksburg.  Our promotions are focused primarily on direct mail and special promotional events.   The Company announced in October 2006 that it is evaluating alternatives with respect to the possible sale of the Rainbow Casino.  There can be no assurance that the Company will proceed with or complete the sale of the Rainbow Casino.

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Results of Operations

Our results of operations include the accounts of Bally Technologies, Inc., and its wholly-owned and partially-owned subsidiaries.  We report our revenue and income in two segments: the Bally Gaming Equipment and Systems segment, which includes our Gaming Equipment, Gaming Operations and Systems divisions, and our Casino Operations segment.  Revenue from our Bally Gaming and Systems segment represents approximately 93% of our total revenues for the six months ended December 31, 2006.

Bally Gaming Equipment and Systems

The summary financial results and operating statistics for our Bally Gaming Equipment and Systems segment for the three and six months ended December 31, 2006 and 2005 are as follows:

 

		Three Months Ended December 31,												Six Months Ended December 31,
		2006			% Rev		2005			% Rev		Favorable/ (Unfavorable)		2006			% Rev		2005			% Rev		Favorable/ (Unfavorable)
		(dollars in millions)
Revenues
Gaming Equipment		$	72.7		52	%	$	54.1		47	%	34	%	$	136.6		48	%	$	91.4		44	%	49	%
Gaming Operations		38.7			27	%	34.9			31	%	11	%	77.8			28	%	71.8			34	%	8	%
Systems		29.2			21	%	25.0			22	%	17	%	68.2			24	%	45.6			22	%	50	%
Total revenues		$	140.6		100	%	$	114.0		100	%	23	%	$	282.6		100	%	$	208.8		100	%	35	%
Gross margin
Gaming Equipment		$	26.3		36	%	$	15.5		29	%	70	%	$	47.9		35	%	$	24.7		27	%	94	%
Gaming Operations		22.6			58	%	13.6			39	%	66	%	44.8			58	%	32.6			45	%	37	%
Systems		21.0			72	%	19.6			78	%	7	%	46.2			68	%	37.3			82	%	24	%
Total gross margin		$	69.9		50	%	$	48.7		43	%	44	%	$	138.9		49	%	$	94.6		45	%	47	%
Selling, general and administrative		$	42.7		30	%	$	37.1		33	%	(15	)%	$	83.9		30	%	$	69.5		33	%	(21	)%
Research and development costs		13.3			9	%	10.7			9	%	(24	)%	25.9			9	%	21.0			10	%	(23	)%
Depreciation and amortization		4.7			3	%	5.7			5	%	18	%	9.0			3	%	10.3			5	%	13	%
Operating income (loss)		$	9.2		7	%	$	(4.8	)	(4	)%	292	%	$	20.1		7	%	$	(6.2	)	(3	)%	424	%

 

		Three Months Ended December 31,								Six Months Ended December 31,
		2006			2005			Favorable/ (Unfavorable)		2006			2005			Favorable/ (Unfavorable)
Operating Statistics:
New gaming devices sold		4,672			3,663			28	%	8,099			6,463			25	%
OEM units sold		460			305			51	%	1,605			326			392	%
New unit average selling price		$	12,620		$	10,921		16	%	$	12,363		$	10,802		14	%
Gaming monitoring units installed base										287,000			266,000			8	%
Casino management systems installed base										563			532			6	%
Systems managed cashless games										231,000			161,000			43	%
End of period installed base:
Wide-area progressive										935			1,305			(28	)%
Local-area progressive										544			611			(11	)%
Total linked progressive systems										1,479			1,916			(23	)%
Rental and daily-fee games										4,636			2,783			67	%
Lottery Systems										7,164			6,713			7	%
Centrally determined Systems										31,244			23,631			32	%

 

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Three Months Ended December 31, 2006 Compared to Three Months Ended December 31, 2005

Total revenues for our Bally Gaming Equipment and Systems segment increased $26.6 million, or 23%, for the three months ended December 31, 2006 as compared to the corresponding period in the prior year.  This increase was the result of higher revenues from our Gaming Equipment, Gaming Operations and Systems divisions of 34%, 11%, and 17%, respectively.  A more detailed description of the fluctuations in revenues of each Bally Gaming Equipment and Systems segment is set forth below.

Gaming Equipment.  Gaming Equipment revenue increased by $18.6 million, or 34%, for the three months ended December 31, 2006, as compared to the corresponding period in the prior year, primarily a result of the following:

·                  An increase in new gaming device sales of 1,009 units, or 28%, to 4,672 units in the three months ended December 31, 2006 from 3,663 units in the corresponding period in the prior year.

·                  A 16% increase in the Average Selling Price (“ASP”) of new gaming units, excluding OEM sales, as ASP in the prior year was negatively affected by introductory pricing related to the roll-out of devices based on the ALPHA OS platform.

·                  An increase in OEM units sold of 155 units to 460 units in the three months ended December 31, 2006 from 305 units in the corresponding period in the prior year. Sales of OEM products vary significantly from period to period based on deployments by our OEM customers, and are typically sold at lower selling prices and margins than sales made directly to casino operators.

Gaming Equipment Gross Margin.  Gaming Equipment gross margin increased to 36% in the three months ended December 31, 2006, from 29% in the corresponding period in the prior year, primarily as a result of:

·                  Introductory pricing in the prior year period related to the roll-out of the ALPHA OS platform.

·                  Inventory write-downs in the prior year period of $4.1 million, or 8% of gaming equipment revenue, compared to $1.8 million, or 2% of gaming revenue, in the current period.

Gaming Operations.  Gaming Operations revenue increased by $3.8 million, or 11%, primarily as a result of the following:

·                  An $8.5 million, or 51%, increase in revenue from rental and daily fee, lottery and centrally determined games resulting from a 30% increase in the installed base of games over the prior year period.

·      A reduction in wide-area progressive revenues of $2.8 million resulting from a 28% decrease in the installed base of games during the period.

Gaming Operations Gross Margin.  Gaming Operations gross margin, which includes depreciation expense of $8.0 million and $11.4 million for the three months ended December 31, 2006 and 2005, respectively, increased to 58%, from 39%, primarily as a result of a reduction in expenditures to fund jackpot liabilities of $1.6 million resulting from a 28% decrease in the installed base of wide-area progressive games during the period. Also, a change in the estimated useful life and salvage values for certain gaming equipment used in the Gaming Operations division resulted in an increase in depreciation expense charged to cost of gaming operations during the prior year period.

Systems.  Systems revenue increased by $4.2 million, or 17%, primarily as a result of the following:

·                  An increase of $1.5 million, or 22%, in systems service and maintenance fees related to certain contracts with major domestic customers.

·                  An increase of $2.3 million, or 102%, in systems hardware sales primarily related our SDS and iView products.

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Systems Gross Margin.  Systems gross margin declined to 72% in the three months ended December 31, 2006, as compared to 78% in the corresponding period in the prior year, as a result of the increased proportion of hardware sales in the current period, which have lower gross margins compared to software sales.

Selling, General and Administrative Expense.  Selling, general, and administrative expenses increased by $5.6 million, or 15%, primarily as a result of:

·                  An increase in payroll and related expenses and casual labor of $6.4 million in the three months ended December 31, 2006, as compared to the corresponding period of the prior year, to support the increased growth of our business.

·                  An increase in consulting and license fees of $1.6 million due to increased third-party development and engineering services.

Research and Development Costs. Research and development costs increased by $2.6 million, or 24%, primarily as a result of an increase in payroll and related expenses in the three month period ended December 31, 2006 as compared to the corresponding period in the prior year.  The increase in research and development reflects our focus on our technology assets and the competitive landscape that requires a continuous investment in the development of future generations of gaming products and systems.

Depreciation and Amortization Expense.  Depreciation and amortization expense decreased by $1.0 million, or 18%, for the three months ended December 31, 2006, as compared to the corresponding period in the prior year, primarily due to a change in the estimated useful life and salvage values for certain gaming equipment in the prior year.

Six Months Ended December 31, 2006 Compared to Six Months Ended December 31, 2005

Total revenues for our Bally Gaming Equipment and Systems segment increased $73.8 million, or 35%, for the six months ended December 31, 2006 as compared to the corresponding period in the prior year.  This increase was the result of an increase in revenues from our Gaming Equipment, Gaming Operations and Systems divisions of 49%, 8%, and 50%, respectively. A more detailed description of the fluctuations in revenues of each Bally Gaming Equipment and Systems segment is set forth below.

Gaming Equipment.  Gaming Equipment revenue increased by $45.2 million, or 49%, for the six months ended December 31, 2006, as compared to the corresponding period in the prior year, primarily as a result of the following:

·                  An increase in new gaming units sold of 1,636 units, or 25%, to 8,099 units in the six months ended December 31, 2006 from 6,463 units in the corresponding period in the prior year.

·                  A 14% increase in the ASP of new gaming units, excluding OEM sales, as ASP in the prior year was negatively affected by introductory pricing related to the roll-out of devices based on the ALPHA OS platform.

·                  An increase in OEM units sold of 1,279 units to 1,605 units in the six months ended December 31, 2006 from 326 units in the corresponding period in the prior year. Sales of OEM products vary significantly from period to period based on deployments by our OEM customers, and are typically sold at lower selling prices and margins than sales made directly to casino operators.

·                  The recognition of OEM license revenue of $4.9 million in the six months ended December 31, 2006 resulting from the sale of content licenses to an OEM customer.

Gaming Equipment Gross Margin.  Gaming Equipment gross margin improved to 35% for the six months ended December 31, 2006, from 27% in the corresponding period in the prior year, primarily as a result of:

·                  Introductory pricing in the prior year period related to the roll-out of the ALPHA OS platform.

·                  Higher production costs in the prior year period related to the initial manufacture of devices based on the ALPHA OS platform.

·                  Inventory write-downs in the prior year period of $8.0 million, or 9% of gaming equipment revenue, compared to $6.2 million, or 5% of gaming equipment revenue, in the current period.

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Gaming Operations. Gaming Operations revenues increased by $6.0 million, or 8%, primarily as a result of the following:

·                  A $13.3 million, or 38%, increase in revenue from rental and daily fee, lottery and centrally determined games resulting from a 30% increase in the installed base of games over the prior year period.

·      A reduction in wide area progressive revenue of $6.1 million resulting from a 28% decrease in the installed base of games during the period.

Gaming Operations Gross Margin.  Gaming Operations gross margin, which includes depreciation expense of $17.3 million and $18.1 million for the six months ended December 31, 2006 and 2005, respectively, increased to 58%, from 45%, primarily as a result of a reduction in expenditures to fund jackpot liabilities of $7.1 million due to the decrease in the installed base of wide-area progressive games during the period. Also, a change in the estimated useful life and salvage values for certain gaming equipment used in the Gaming Operations division resulted in an increase in depreciation expense charged to cost of gaming operations during the prior year period.

Systems.  Systems revenue increased by $22.6 million, or 50%, primarily as a result of the following:

·                  An increase of $2.1 million, or 15%, in systems service and maintenance fees related to certain contracts with major domestic customers.

·                  An increase of $21.1 million, or 96%, in systems hardware sales primarily related to sales of our SDS and iView products.

Systems Gross Margin.  Systems gross margin declined to 68% in the six months ended December 31, 2006, from 82% in the corresponding period in the prior year, as a result of the increased proportion of hardware sales in the current period, which have lower gross margins compared to software sales.

Selling, General and Administrative Expense. Selling, general and administrative expenses for the segment increased by $14.4 million, or 21%, primarily as a result of:

·                  An increase in payroll and related expenses and casual labor of $14.0 million in the six months ended December 31, 2006, as compared to the corresponding period of the prior year, to support the increased growth of our business.

·                  An increase in legal expense of $3.3 million due to higher litigation costs and patent costs.

·                  An increase in consulting and license fees of $1.6 million due to increased third-party development and engineering services.

Research and Development Costs.  Research and development costs increased by $4.9 million, or 23%, primarily as a result of an increase in payroll and related expenses in the six month period ended December 31, 2006, as compared to the corresponding period in the prior year.  The increase in research and development reflects our focus on our technology assets and the competitive landscape that requires a continuous investment in the development of future generations of gaming products and systems.

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Depreciation and Amortization Expense.  Depreciation and amortization expense decreased by $1.3 million, or 13%, for the six months ended December 31, 2006, as compared to the corresponding period last year, primarily due to a change in the estimated useful life and salvage values for certain gaming equipment in the prior year.

Casino Operations

The Rainbow Casino is one of four casinos currently operating in the Vicksburg, Mississippi market. The casino draws customers primarily from a 75-mile radius surrounding Vicksburg, which includes Jackson, Mississippi.  In fiscal 2007, we began considering the possible sale of Rainbow to a third party in connection with our plans to focus our efforts on our technology assets.  The conditions under which we may sell Rainbow are dynamic and may be impacted by a number of factors including, but not limited to, general market conditions, competition, our financial position and the interest of certain buyers who may be strategic to us.  If we do not receive a financially beneficial offer, we may decide not to sell the casino.  The summary of our financial results and operating statistics for our Casino Operation are as follows:

		Three Months Ended December 31,												Six Months Ended December 31,
		2006			% Rev		2005			% Rev		Favorable/ (Unfavorable)		2006			% Rev		2005			% Rev		Favorable/ (Unfavorable)
		(dollars in millions)
Revenue		$	11.2		100	%	$	13.5		100	%	(17	)%	$	23.1		100	%	$	24.2		100	%	(5	)%
Gross margin		6.8			61	%	8.6			64	%	(21	)%	14.2			61	%	14.9			62	%	(5	)%
Selling, general and administrative		2.1			19	%	2.6			19	%	19	%	4.6			20	%	4.7			19	%	2	%
Depreciation and amortization		0.8			7	%	0.9			7	%	11	%	1.6			7	%	1.8			7	%	11	%
Operating income		$	3.9		35	%	$	5.1		38	%	(24	)%	$	8.0		35	%	$	8.4		35	%	(5	)%
Operating statistics:
Average number of gaming devices		852					905					(6	)%	893					921					(3	)%
Average number of table games		11					12					(8	)%	11					12					(8	)%

 

Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation.  Specifically, certain promotional expenses representing coupons redeemable for cash incentives, totaling $1.0 million and $1.9 million for the three and six months ended December 31, 2005, have been reclassified from selling, general and administrative expense and offset against Casino Operations revenue.

Three Months Ended December 31, 2006 Compared to Three Months Ended December 31, 2005

Casino Operations revenue decreased 17% for the three months ended December 31, 2006 as compared to the corresponding period in the prior year.  A portion of the decrease was attributable to a decrease in the average number of gaming devices of 53, or 6%, from 905 during the three months ended December 31, 2005, to 852 during the same period this year. The remainder of the decrease in revenue is due to the fact that revenue in the prior year was positively impacted due to the fact our property, unlike our competitor’s properties, did not sustain any significant damage in connection with the Gulf Coast hurricanes in August and September 2005.

Overall gross margin decreased 21% due to the decrease in revenue coupled with the fixed nature of our direct cost of gaming expenses.

Selling, general and administrative expenses decreased by 19% due to a decline in advertising and promotional expenses for the three months ended December 31, 2006 as compared to the corresponding period in the prior year.

Depreciation and amortization expense, as a percentage of revenue, remained consistent over the corresponding period in the prior year.

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