UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




Form
10-Q




(Mark
One)


ý
              QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
quarterly period ended December
31, 2008


OR


 ̈
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934




For the
transition period from ______ to ______




Commission
File Number: 000-28318




Multimedia
Games, Inc.


(Exact
name of Registrant as specified in its charter)




Texas
            74-2611034(State or other jurisdiction of incorporation or organization)
            (IRS Employer Identification No.)206
      Wild Basin Road, Building B, Fourth FloorAustin,
      Texas
            78746(Address
      of principal executive offices)
            (Zip
      Code)




(512)
334-7500


(Registrant’s
telephone number, including area code)




Registrant’s
website: www.multimediagames.com




None


(Former
name, former address and former fiscal year, if changed since last
report)




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




Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act:




Large
      Accelerated Filer  ̈
                Accelerated
      Filer ýNon-Accelerated
      Filer  ̈
                Smaller
      Reporting Company  ̈




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




As of
February 2, 2009, there were 26,642,942 shares of the Registrant’s
common stock, par value $0.01 per share, outstanding.







FORM
10-Q
  INDEX


PART
      I.  FINANCIAL INFORMATIONItem
      1.
                                          Condensed
      Financial Statements (Unaudited)Consolidated
      Balance Sheets(As
      of December 31, 2008and September 30,
      2008)
                                          
                                          3Consolidated
      Statements of Operations(For
      the three months ended December 31, 2008 and 2007)
                                          
                                          5Consolidated
      Statements of Cash Flows(For
      the three months ended December 31, 2008and
      2007)
                                          
                                          6Notes
      to Consolidated Financial Statements
                                          
                                          7Item
      2.
                                          Management’s
      Discussion and Analysisof
      Financial Condition and Results of Operations
                                          
                                          21Item
      3.
                                          Quantitative
      and Qualitative Disclosures about Market Risk
                                          
                                          33Item
      4.
                                          Controls
      and Procedures
                                          
                                          33PART
      II.  OTHER INFORMATIONItem
      1.
                                          Legal
      Proceedings
                                          
                                          35Item
      1A.
                                          Risk
      Factors
                                          
                                          35Item
      2.
                                          Unregistered
      Sales of Equity Securities and Use of Proceeds
                                          
                                          45Item
      3.
                                          Defaults
      upon Senior Securities
                                          
                                          45Item
      4.
                                          Submission
      of Matters to a Vote of Security Holders
                                          
                                          45Item
      5.
                                          Other
      Information
                                          
                                          45Item
      6.
                                          Exhibits
                                          
                                          45Signatures
                                          
                                          46Exhibit
      Index


-2-




PART
I
 FINANCIAL
INFORMATION
  Item
1. Condensed Financial Statements
  MULTIMEDIA
GAMES, INC.




CONSOLIDATED
BALANCE SHEETS


As of
December 31, 2008 and September 30,
2008


(In
thousands, except shares)


(Unaudited)





December 31,
                                            2008
                                          
                                          
                                          September 30,
                                            2008ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                                          
                                          $
                                          2,940
                                          
                                          
                                          $
                                          6,289Accounts
      receivable, net of allowance for doubtful accounts of $1,112 and $1,209,
      respectively
                                          
                                          
                                          21,778
                                          
                                          
                                          
                                          23,566Inventory
                                          
                                          
                                          5,500
                                          
                                          
                                          
                                          2,445Deferred
      contract costs
                                          
                                          
                                          1,454
                                          
                                          
                                          
                                          998Prepaid
      expenses and other
                                          
                                          
                                          2,032
                                          
                                          
                                          
                                          2,170Current
      portion of notes receivable, net
                                          
                                          
                                          18,688
                                          
                                          
                                          
                                          23,072Federal
      and state income tax receivable
                                          
                                          
                                          4,751
                                          
                                          
                                          
                                          2,198Deferred
      income taxes
                                          
                                          
                                          7,852
                                          
                                          
                                          
                                          6,876Total
      current assets
                                          
                                          
                                          64,995
                                          
                                          
                                          
                                          67,614Restricted
      cash and long-term investments
                                          
                                          
                                          838
                                          
                                          
                                          
                                          868Leased
      gaming equipment, net
                                          
                                          
                                          40,602
                                          
                                          
                                          
                                          36,024Property
      and equipment, net
                                          
                                          
                                          75,509
                                          
                                          
                                          
                                          67,329Long-term
      portion of notes receivable, net
                                          
                                          
                                          48,688
                                          
                                          
                                          
                                          46,690Intangible
      assets, net
                                          
                                          
                                          36,020
                                          
                                          
                                          
                                          37,356Other
      assets
                                          
                                          
                                          3,410
                                          
                                          
                                          
                                          4,157Deferred
      income taxes
                                          
                                          
                                          16,813
                                          
                                          
                                          
                                          16,902Total
      assets
                                          
                                          $
                                          286,875
                                          
                                          
                                          $
                                          276,940LIABILITIES
      AND STOCKHOLDERS’ EQUITYCURRENT
      LIABILITIES:Current
      portion of long-term debt
                                          
                                          $
                                          2,675
                                          
                                          
                                          $
                                          1,544Accounts
      payable and accrued expenses
                                          
                                          
                                          38,981
                                          
                                          
                                          
                                          29,248Federal
      and state income tax payable
                                          
                                          
                                          —
                                          
                                          
                                          
                                          33Deferred
      revenue
                                          
                                          
                                          3,600
                                          
                                          
                                          
                                          2,640Total
      current liabilities
                                          
                                          
                                          45,256
                                          
                                          
                                          
                                          33,465Revolving
      line of credit
                                          
                                          
                                          25,222
                                          
                                          
                                          
                                          19,000Long-term
      debt, less current portion
                                          
                                          
                                          66,222
                                          
                                          
                                          
                                          66,444Other
      long-term liabilities
                                          
                                          
                                          1,085
                                          
                                          
                                          
                                          1,131Deferred
      revenue, less current portion
                                          
                                          
                                          5,485
                                          
                                          
                                          
                                          6,168Total
      liabilities
                                          
                                          
                                          143,270
                                          
                                          
                                          
                                          126,208Commitments
      and contingenciesStockholders’
      equity:Preferred
      stock:Series
      A, $0.01 par value, 1,800,000 shares authorized,no
      shares issued and outstanding
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Series
      B, $0.01 par value, 200,000 shares authorized,no
      shares issued and outstanding
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Common
      stock, $0.01 par value, 75,000,000 shares authorized,32,545,809
      and 32,511,988 shares issued, and26,642,392
      and 26,608,571 shares outstanding, respectively
                                          
                                          
                                          325
                                          
                                          
                                          
                                          325


-3-





MULTIMEDIA
GAMES, INC.


CONSOLIDATED
BALANCE SHEETS –
(Continued)


As of
December 31, 2008 and September 30,
2008


(In
thousands, except shares)


(Unaudited)





December 31,
                        2008
                      
                      
                      September 30,
                        2008Additional
      paid-in capital
                      
                      
                      83,791
                      
                      
                      
                      83,076Treasury
      stock, 5,903,417 common shares at cost
                      
                      
                      (50,128
                      )
                      
                      
                      (50,128
                      )Retained
      earnings
                      
                      
                      111,657
                      
                      
                      
                      117,581Accumulated
      other comprehensive loss, net
                      
                      
                      (2,040
                      )
                      
                      
                      (122
                      )Total
      stockholders’ equity
                      
                      
                      143,605
                      
                      
                      
                      150,732Total
      liabilities and stockholders’ equity
                      
                      $
                      286,875
                      
                      
                      $
                      276,940





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


-4-


MULTIMEDIA
GAMES, INC.
 CONSOLIDATED STATEMENTS
OF OPERATIONS


For
the Three Months Ended December 31, 2008 and 2007


(In
thousands, except per share data)


(Unaudited)





Three Months Ended
                                        December 31,2008
                                      
                                      
                                      2007REVENUES:Gaming revenue:Class II
                                      
                                      $
                                      5,007
                                      
                                      
                                      $
                                      8,040Oklahoma
      compact
                                      
                                      
                                      13,796
                                      
                                      
                                      
                                      11,561Charity
                                      
                                      
                                      2,543
                                      
                                      
                                      
                                      3,857All
      other
                                      
                                      
                                      4,940
                                      
                                      
                                      
                                      4,638Gaming equipment, system sale
      and lease revenue
                                      
                                      
                                      1,766
                                      
                                      
                                      
                                      1,771Other
                                      
                                      
                                      524
                                      
                                      
                                      
                                      368Total revenues
                                      
                                      
                                      28,576
                                      
                                      
                                      
                                      30,235OPERATING
      COSTS AND EXPENSES:Cost
      of gaming equipment and systems soldand
      royalty fees
                                      
                                      
                                      1,847
                                      
                                      
                                      
                                      790Selling, general and
      administrative expenses
                                      
                                      
                                      20,264
                                      
                                      
                                      
                                      16,101Amortization and
      depreciation
                                      
                                      
                                      14,865
                                      
                                      
                                      
                                      12,523Total operating costs and
      expenses
                                      
                                      
                                      36,976
                                      
                                      
                                      
                                      29,414Operating income
      (loss)
                                      
                                      
                                      (8,400
                                      )
                                      
                                      
                                      821OTHER
      INCOME (EXPENSE):Interest income
                                      
                                      
                                      1,290
                                      
                                      
                                      
                                      1,134Interest
expense
                                      
                                      
                                      (2,135
                                      )
                                      
                                      
                                      (2,140
                                      )Other income
                                      
                                      
                                      74
                                      
                                      
                                      
                                      338Income
      (loss) before income taxes
                                      
                                      
                                      (9,171
                                      )
                                      
                                      
                                      153Income
      tax benefit
                                      
                                      
                                      3,247
                                      
                                      
                                      
                                      246Net income (loss)
                                      
                                      $
                                      (5,924
                                      )
                                      
                                      $
                                      399Basic
      earnings (loss) per common share
                                      
                                      $
                                      (0.22
                                      )
                                      
                                      $
                                      0.02Diluted
      earnings (loss) per common share
                                      
                                      $
                                      (0.22
                                      )
                                      
                                      $
                                      0.01Shares
      used in earnings (loss) per common share:Basic
                                      
                                      
                                      26,624
                                      
                                      
                                      
                                      26,254Diluted
                                      
                                      
                                      26,624
                                      
                                      
                                      
                                      27,380





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


-5-





MULTIMEDIA
GAMES, INC.


CONSOLIDATED STATEMENTS OF CASH
FLOWS


For
the Three Months EndedDecember 31, 2008and
2007


(In
thousands)


(Unaudited)





Three Months Ended
                            December 31,2008
                          
                          
                          2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income (loss)
                          
                          $
                          (5,924
                          )
                          
                          $
                          399Adjustments
      to reconcile net income (loss) to cash providedby
      operating activities:Amortization
                          
                          
                          1,388
                          
                          
                          
                          1,202Depreciation
                          
                          
                          13,477
                          
                          
                          
                          11,321Accretion
      of contract rights
                          
                          
                          1,326
                          
                          
                          
                          996Provisions
      for long-lived assets
                          
                          
                          (1,142
                          )
                          
                          
                          (5
                          )Deferred
      income taxes
                          
                          
                          (887
                          )
                          
                          
                          (1,877
                          )Share-based
      compensation
                          
                          
                          654
                          
                          
                          
                          367Provision
      for doubtful accounts
                          
                          
                          149
                          
                          
                          
                          161Interest
      income from imputed interest
                          
                          
                          (1,152
                          )
                          
                          
                          (804
                          )Changes
      in operating assets and liabilities:Accounts
      receivable
                          
                          
                          (572
                          )
                          
                          
                          847Inventory
                          
                          
                          (3,055
                          )
                          
                          
                          1,157Deferred
      contract costs
                          
                          
                          (456
                          )
                          
                          
                          (116
                          )Prepaid
      expenses and other
                          
                          
                          885
                          
                          
                          
                          86Federal
      and state income tax payable/receivable
                          
                          
                          (2,586
                          )
                          
                          
                          (1,488
                          )Notes
      receivable
                          
                          
                          1,151
                          
                          
                          
                          (230
                          )Accounts
      payable and accrued expenses
                          
                          
                          9,733
                          
                          
                          
                          1,075Other
      long-term liabilities
                          
                          
                          (16
                          )
                          
                          
                          —Deferred
      revenue
                          
                          
                          277
                          
                          
                          
                          (2,128
                          )NET
      CASH PROVIDED BY OPERATING ACTIVITIES
                          
                          
                          13,250
                          
                          
                          
                          10,963CASH
      FLOWS USED IN INVESTING ACTIVITIES:Acquisition
      of property and equipment and leased gaming equipment
                          
                          
                          (25,058
                          )
                          
                          
                          (12,311
                          )Proceeds
      from disposal of assets
                          
                          
                          —
                          
                          
                          
                          252Acquisition
      of intangible assets
                          
                          
                          (845
                          )
                          
                          
                          (1,518
                          )Advances
      under development agreements
                          
                          
                          —
                          
                          
                          
                          (20,162
                          )Repayments
      under development agreements
                          
                          
                          1,819
                          
                          
                          
                          5,683NET
      CASH USED IN INVESTING ACTIVITIES
                          
                          
                          (24,084
                          )
                          
                          
                          (28,056
                          )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from exercise of stock options, warrants,and related tax
      benefit
                          
                          
                          61
                          
                          
                          
                          134Proceeds
      from long-term debt
                          
                          
                          2,894
                          
                          
                          
                          424Principal
      payments of long-term debt and capital leases
                          
                          
                          (1,985
                          )
                          
                          
                          (180
                          )Proceeds
      from revolving lines of credit
                          
                          
                          6,444
                          
                          
                          
                          14,097Payments
      on revolving lines of credit
                          
                          
                          (222
                          )
                          
                          
                          (3,000
                          )NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                          
                          
                          7,192
                          
                          
                          
                          11,475EFFECT
      OF EXCHANGE RATES ON CASH
                          
                          
                          293
                          
                          
                          
                          (1
                          )Net
      decrease in cash and cash equivalents
                          
                          
                          (3,349
                          )
                          
                          
                          (5,619
                          )Cash
      and cash equivalents, beginning of period
                          
                          
                          6,289
                          
                          
                          
                          5,805Cash
      and cash equivalents, end of period
                          
                          $
                          2,940
                          
                          
                          $
                          186SUPPLEMENTAL
      CASH FLOW DATA:Interest
      paid
                          
                          $
                          681
                          
                          
                          $
                          1,215Income
      tax paid
                          
                          $
                          208
                          
                          
                          $
                          3,366NON-CASH
      TRANSACTIONS:Contract
      rights resulting from imputed interest on development agreement notes
      receivable
                          
                          $
                          568
                          
                          
                          $
                          3,257




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


-6-




MULTIMEDIA
GAMES, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


1.      SIGNIFICANT
ACCOUNTING POLICIES




The
accompanying condensed consolidated financial statements should be read in
conjunction with the Company’s consolidated financial statements and footnotes
contained within the Company’s Annual Report on Form 10-K for the year
ended September 30, 2008, as amended by Amendment No. 1 on
Form 10-K/A thereto.




The
financial statements included herein as of December 31, 2008, and for
each of the three months ended December 31, 2008 and 2007, have
been prepared by the Company without an audit, pursuant to accounting principles
generally accepted in the United States, and the rules and regulations of the
Securities and Exchange Commission, or SEC. They do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. The information
presented reflects all adjustments consisting solely of normal recurring
adjustments which are, in the opinion of management, considered necessary to
present fairly the financial position, results of operations, and cash flows for
the periods. Operating results for the three months ended
December 31, 2008, are not necessarily indicative of the results which
will be realized for the year ending September 30, 2009.




Operations –The Company is a supplier of interactive systems, server-based gaming
systems, interactive electronic games, player terminals, stand-alone player
terminals, video lottery terminals, electronic scratch ticket systems,
electronic instant lottery systems, player tracking systems, casino cash
management systems, slot accounting systems, slot management systems, unified
currencies and electronic and paper bingo systems for Native American, racetrack
casino, casino, charity and commercial bingo, sweepstakes, lottery and video
lottery markets and the Company provides support and services and operations
support for its customers and products. The Company designs and develops
networks, software and content that provide its customers with, among other
things, comprehensive gaming systems, some of which are delivered through a
telecommunications network that links its player terminals with one another,
both within and among gaming facilities. The Company’s ongoing development and
marketing efforts focus on Class II and Class III gaming systems and
products for use by Native American tribes; video lottery terminals, video
lottery systems, stand-alone player terminals, electronic instant scratch
systems and other products for domestic and international lotteries; products
for domestic and international charity and commercial bingo markets; and
promotional, sweepstakes and amusement with prize systems. The Company’s gaming
systems are typically provided to customers under revenue-sharing arrangements,
except for video lottery terminals in the Class III market in Washington
State, which are typically sold for an up-front purchase price. The Company has
undertaken a concerted effort to generate additional revenue through the sale of
Class II and Class III gaming systems and products. The Company offers
content for its gaming systems that has been designed and developed by the
Company, as well as game themes the Company has licensed from others. The
Company currently operates in one business segment.




Consolidation
Principles –The Company’s financial statements include the accounts of
Multimedia Games, Inc. and its wholly-owned subsidiaries: Megabingo, Inc., MGAM
Systems, Inc., Innovative Sweepstakes Systems, Inc., MGAM Services, LLC,
MGAM Systems International, Inc., Megabingo International, LLC,
Multimedia Games de Mexico 1, S. de R.L. de C.V., and
Servicios de Wild Basin S. de R.L. de C.V. Intercompany
balances and transactions have been eliminated.




Accounting
Estimates–The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenues and
expenses during the reporting period. Examples include share-based compensation,
provisions for doubtful accounts and contract losses, estimated useful lives of
property and equipment and intangible assets, impairment of property and
equipment and intangible assets, deferred income taxes, and the provision for
and disclosure of litigation and loss contingencies. Actual results may differ
materially from these estimates in the future.




Revenue
Recognition–In
accordance with the provision of Staff Accounting Bulleting No. 104,
“Revenue Recognition,” or SAB 104, the Company recognizes revenue when all
of the following have been satisfied:




§
            Persuasive
      evidence of an arrangement exists;




§
            Delivery
      has occurred;




§
            Price
      to the buyer is fixed or determinable;
and




§
            Collectibility
      is probable.


-7-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)


Gaming
Revenue




The
Company derives gaming revenue from the following sources:




·
            Class II
            –
            Participation
      revenue generated from the Company’s Native American Class II
      product·
            Oklahoma
      Compact
            –
            Participation
      revenue generated from its games placed by the Company under the Oklahoma
      Compact·
            Charity
            –
            Participation
      revenue generated from its charity bingo product·
            All
      Other
            –
            Participation
      revenue from Class III back-office systems, New York Lottery system,
      Mexico bingo market, and certain other participation-based
      markets




The
majority of the Company’s gaming revenue is of a recurring nature, and is
generated under lease participation arrangements when the Company provides its
customers with player terminals, player terminal-content licenses and
back-office equipment, collectively referred to as gaming equipment. Under these
arrangements, the Company retains ownership of the gaming equipment installed at
customer facilities, and the Company receives revenue based on a percentage of
the net win per day generated by the gaming equipment. Revenue from lease
participation arrangements are considered both realizable and earned at the end
of each gaming day.




Gaming
Revenue generated by player terminals deployed at sites under development
agreements is reduced by the accretion of contract rights from those development
agreements. Contract rights are amounts allocated to intangible assets for
dedicated floor space resulting from development agreements, described under
“Development Agreements.” The related amortization expense, or accretion of
contract rights, is netted against its respective revenue category in the
consolidated statements of operations.




The
Company also generates gaming revenues from back-office fees with certain
customers. Back-office fees cover the service and maintenance costs for
back-office servers installed in each gaming facility to run its gaming
equipment, as well as the cost of related software updates. Back-office fees are
considered both realizable and earned at the end of each gaming
day.




Gaming
equipment and system sales




The
Company periodically sells gaming equipment and gaming systems under independent
sales contracts through normal credit terms or may grant extended credit terms
under contracts secured by the related equipment, with interest recognized at
market rates.




For sales
arrangements with multiple deliverables, the Company applies the guidance from
Statement of Position, or SOP 97-2, “Software Revenue Recognition,” as amended,
and Emerging Issues Task Force, or EITF 00-21, “Revenue Arrangements with
Multiple Deliverables.” Deliverables are divided into separate units of
accounting if: (i) each item has value to the customer on a stand-alone
basis; (ii) there is objective and reliable evidence of the fair value of
the undelivered items; and (iii) delivery of the undelivered item is
considered probable and substantially in the Company’s control.




The
majority of the Company’s multiple element sales contracts are for some
combination of gaming equipment, player terminals, content, system software,
license fees and maintenance. For multiple element contracts considered a single
unit of accounting, the Company recognizes revenues based on the method
appropriate for the last delivered item.




The
Company allocates revenue to each accounting unit based upon its fair value as
determined by Vendor Specific Objective Evidence, or VSOE. VSOE of fair value
for all elements of an arrangement is based upon the normal pricing and
discounting practices for those products and services when sold individually.
The Company recognizes revenue when the product is physically delivered to a
customer controlled location or over the period in which the service is
performed and defers revenue for any undelivered elements.




§
            In
      those situations where each element is not essential to the function of
      the other, the “multiple deliverables” are bifurcated into accounting
      units based on their relative fair market value against the total contract
      value and revenue recognition on those deliverables is recorded when all
      requirements of revenue recognition have been
  met.




§
            If
      any element is determined to be essential to the function of the other,
      revenues are generally recognized over the term of the services that are
      rendered.


-8-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)




In those
situations where VSOE does not exist for any undelivered elements of a multiple
element arrangement, the aggregate value of the arrangement, including the value
of products and services delivered or performed, is initially deferred until all
hardware and software is delivered, and then the entire amount of the
arrangement is recognized ratably over the period of the last deliverable,
generally the service period of the contract. Depending upon the elements and
the terms of the arrangement, the Company recognizes certain revenues under the
residual method. Under the residual method, revenue is recognized when VSOE
of fair value exists for all of the undelivered elements in the arrangement, but
does not exist for one or more of the delivered elements in the arrangement.
Under the residual method, the Company defers the fair value of undelivered
elements, and the remainder of the arrangement fee is then allocated to the
delivered elements and is recognized as revenue, assuming the other revenue
recognition criteria are met.




Costs and
Billings on Uncompleted Contract-During fiscal 2008,
the Company entered into a fixed-price contract with a customer, pursuant to
which it will deliver an electronic bingo system. Revenues from this fixed-price
contract will be recognized on the completed-contract method in accordance with
American Institute of Certified Public Accountants Statement of
Position 81-1, or SOP 81-1, “Accounting for Performance of
Construction-Type and Certain Production-Type Contracts.” In the event that the
Company expected a loss on a contract accounted for under SOP 81-1, the Company
would record the estimated loss in the quarter in which it was determined that a
loss was expected.




Contract
costs include all direct material and labor costs, and those indirect costs
related to contract performance, such as indirect labor, supplies and tools.
General and administrative costs are charged to expense as incurred. Provisions
for estimated losses on uncompleted contracts are made in the period in which
such losses are determined.




Costs in
excess of amounts billed are classified as current assets under “Deferred
contract costs.”




At
December 31, 2008, the following amounts were recorded in the
Company’s consolidated financial statements:




December 31,
                        2008(in
      thousands)Costs
      incurred on uncompleted contracts
                      
                      $
                      2,091Billings
      on uncompleted contracts
                      
                      
                      (637
                      )Deferred
      contract costs
                      
                      $
                      1,454




Cash and Cash
Equivalents –The Company considers all highly liquid investments (i.e.,
investments which, when purchased, have original maturities of three months or
less) to be cash equivalents.




Restricted Cash
and Long-Term Investments –Restricted cash and long-term investments at
December 31, 2008, were $838,000, representing the fair value of
investments held by the Company’s prize fulfillment firm related to outstanding
MegaBingo® jackpot
prizes.




Allowance for
Doubtful Accounts –The Company maintains an allowance for doubtful
accounts related to its accounts receivable and notes receivable that have been
deemed to have a high risk of uncollectibility. Management reviews its accounts
receivable and notes receivable on a monthly basis to determine if any
receivables will potentially be uncollectible. Management analyzes historical
collection trends and changes in its customer payment patterns, customer
concentration, and creditworthiness when evaluating the adequacy of its
allowance for doubtful accounts. In its overall allowance for doubtful accounts,
the Company includes any receivable balances where uncertainty exists as to
whether the account balance has become uncollectible. Based on the information
available, management believes the allowance for doubtful accounts is adequate;
however, actual write-offs might exceed the recorded allowance.




Inventory –The Company’s inventory consists primarily of completed player terminals,
related component parts and back-office computer equipment expected to be sold
over the next 12 months. Inventories are stated at the lower of cost (first
in, first out) or market.


-9-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)




Property and
Equipment and Leased Gaming Equipment –Property and equipment and leased
gaming equipment are stated at cost. The cost of property and equipment and
leased gaming equipment is depreciated over their estimated useful lives,
generally using the straight-line method for financial reporting, and regulatory
acceptable methods for income tax reporting purposes. Player terminals placed
with customers under participation arrangements are included in leased gaming
equipment. Leased gaming equipment includes a “pool” of rental terminals, i.e.,
the “rental pool.” Rental pool units are those units that have previously been
placed in the field under participation arrangements, but are currently back
with the Company, being refurbished and/or awaiting redeployment. Routine
maintenance of property and equipment and leased gaming equipment is expensed in
the period incurred, while major component upgrades are capitalized and
depreciated over the estimated remaining useful life of the component. Sales and
retirements of depreciable property are recorded by removing the related cost
and accumulated depreciation from the accounts. Gains or losses on sales and
retirements of property are reflected in the Company’s results of
operations.




Management
reviews long-lived asset classes for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to its fair value, which considers
the future undiscounted cash flows expected to be generated by the asset. If
such assets are considered to be impaired, the impairment recognized is measured
by the amount by which the carrying amount of the assets exceeds their fair
value. Assets to be disposed of are reported at the lower of the carrying amount
or the fair value less costs of disposal. The Company did not record any
impairment changes in the quarter ended
December 31, 2008.




Equipment under
Capital Lease –Equipment under capital leases is recorded at the lower
of the present value of the minimum lease payments or the fair value of the
assets. The cost of leased property and equipment is amortized using the
Company’s normal amortization policy, described under “Property and Equipment
and Leased Gaming Equipment.”




Deferred Revenue
–Deferred revenue represents amounts from the sale of gaming equipment
and systems that have been billed, or for which notes receivable have been
executed, but which transaction has not met the Company’s revenue recognition
criteria. The cost of the related gaming equipment and systems has been offset
against deferred revenue. Amounts are classified between current and long-term
liabilities, based upon the expected period in which the revenue will be
recognized.




Other Income -Other income was $74,000 for the three months ended
December 31, 2008. Other income consisted of distributions from a
limited partnership interest, accounted for on the cost basis.




Other Long-Term
Liabilities –Other long-term liabilities at December 31, 2008,
include investments held at fair value by the Company’s prize-fulfillment firm
related to outstanding MegaBingo jackpot-prize-winner annuities
of $838,000. At December 31, 2008, other long term liabilities
also included $248,000 related to a separation agreement with a former
Chief Executive Officer.




Fair Value of
Financial Instruments –The fair value of a financial instrument is the
amount at which the instrument could be exchanged in a current transaction
between willing parties, other than in a forced sale or liquidation. At
December 31, 2008, the carrying amounts for the Company’s financial
instruments, which include accounts and notes receivable, accounts payable, the
Revolving Credit Facility, and long-term debt and capital leases, approximated
fair value.




Segment and
Related Information –Although the Company has a number of operating
divisions, separate segment data has not been presented as they meet the
criteria for aggregation as permitted by Statement of Financial Accounting
Standards, or SFAS No. 131, “Disclosures About Segments of an Enterprise
and Related Information.”




Costs of Computer
Software –Software development costs have been accounted for in
accordance with SFAS No. 86, “Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed.” Under
SFAS No. 86, capitalization of software development costs begins upon
the establishment of technological feasibility and prior to the availability of
the product for general release to customers. We capitalized software
development costs of approximately $640,000 during the period ended
December 31, 2008 and $1.2 million during the period ended
December 31, 2007. Software development costs primarily consist of
personnel costs and rent for related office space. We begin to amortize
capitalized costs when a product is available for general release to customers.
Amortization expense is determined on a product-by-product basis at a rate not
less than straight-line basis over the product’s remaining estimated economic
life, not to exceed five years. Amortization of software development costs was
approximately $1.1 million in the period ended December 31, 2008,
and $716,000 in the period ended December 31, 2007, and is
included in amortization and depreciation in the accompanying consolidated
statements of operations.


-10-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)




Income Taxes –The Company accounts for income taxes using the asset and liability
method and applies the provisions of SFAS, No. 109, “Accounting for
Income Taxes.” Under SFAS No. 109, deferred tax liabilities or assets arise
from differences between the tax basis of liabilities or assets and their bases
for financial reporting, and are subject to tests of recoverability in the case
of deferred tax assets. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
provided for deferred tax assets to the extent realization is not judged to be
more likely than not.




Treasury Stock –The Company utilizes the cost method for accounting for its treasury
stock acquisitions and dispositions.




Share-Based
Compensation – On October 1, 2005, the Company adopted the
provisions of SFAS No. 123(revised), “Share-Based Payment.”
SFAS No. 123(R) is a revision of SFAS No. 123 and supersedes
APB No 25. Among other items, SFAS No. 123(R) eliminated the use
of APB No. 25 and the intrinsic value method of accounting, and
requires the Company to recognize in the financial statements, the cost of
employee services received in exchange for awards of equity instruments, based
on the grant date fair value of those awards. To measure the fair value of stock
options granted to employees, the Company currently utilizes the
Black-Scholes-Merton option-pricing model, consistent with the method used for
pro forma disclosures under SFAS No. 123. SFAS No. 123(R) permits
companies to adopt its requirements using either a “modified prospective”
method, or a “modified retrospective” method. The Company applied the “modified
prospective” method, under which compensation cost is recognized in the
financial statements beginning with the adoption date for all share-based
payments granted after that date, and for all unvested awards granted prior to
the adoption date of SFAS No. 123(R).




The
Black-Scholes-Merton model incorporates various assumptions, including expected
volatility, expected life, and risk-free interest rates. The expected volatility
is based on the historical volatility of the Company’s common stock over the
most recent period commensurate with the estimated expected life of the
Company’s stock options, adjusted for the impact of unusual fluctuations not
reasonably expected to recur. The expected life of an award is based on
historical experience and on the terms and conditions of the stock awards
granted to employees.




There
were 277,000 option grants issued during the quarter ended
December 31, 2008. Total pretax share-based compensation for the
quarter ended December 31, 2008 was $644,000. The total income tax
benefit recognized in the statement of operations for share-based compensation
arrangements was $143,000 for the three months ended
December 31, 2008. As of December 31, 2008,
$5.2 million of unamortized stock compensation expense will be recognized
over the vesting periods of the various option grants.


Foreign Currency
Translation. The Company accounts for currency translation in accordance
with SFAS No. 52, “Foreign Currency Translation.” Balance sheet
accounts are translated at the exchange rate in effect at each balance sheet
date. Income statement accounts are translated at the average rate of exchange
prevailing during the period. Translation adjustments resulting from this
process are charged or credited to other comprehensive income (loss) in
accordance with SFAS 130, “Reporting Comprehensive Income.”




Recent Accounting
Pronouncements Issued. In March 2008, the Financial Accounting
Standards Board, or the FASB issued SFAS No 161, “Disclosures about
Derivative Instruments and Hedging Activities—An Amendment of FASB Statement
No. 133.” SFAS No. 161 enhances required disclosures regarding
derivatives and hedging activities, including enhanced disclosures regarding
how: (a) an entity uses derivative instruments; (b) derivative
instruments and related hedged items are accounted for under SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities; and
(c) derivative instruments and related hedged items affect an entity's
financial position, financial performance, and cash flows. SFAS No. 161 is
effective for fiscal years, and interim periods within those fiscal years,
beginning after November 15, 2008, though earlier application is
encouraged. Accordingly, we expect to adopt SFAS No. 161 beginning in
fiscal 2010. The Company expects that SFAS No. 161 will have an impact
on accounting for derivative instruments and hedging activities once adopted,
but the significance of the effect is dependent upon entering into these related
transactions, if any, at that time.


-11-


MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)




Effective October 1, 2008,
The Company adopted SFAS 157, “Fair Value Measurements,” for its financial
assets and financial liabilities, but it has not yet adopted SFAS 157 as it
relates to nonfinancial assets and liabilities based on the February 2008
issuance of  FASB Staff Position 157-2, “Effective Date of FASB
Statement No. 157,” which permits a one-year deferral of the application of
SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities,
except those that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually) to fiscal years beginning
after November 15, 2008. The adoption of SFAS 157 as it pertains
to financial assets and liabilities did not have a material impact on the
Company’s results of operations, financial position or liquidity. The Company
will adopt SFAS 157 for non-financial assets and non-financial liabilities
on October 1, 2009, and it is currently evaluating the effect, if any,
on its results of operations, financial position or liquidity.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
for Financial Assets and Financial Liabilities, including an amendment of FASB
Statement No. 115 (Accounting for Certain Investments in Debt and Equity
Securities),” which permits entities to choose to measure many financial
instruments and certain other items at fair value with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement became effective for the Company beginning in
October 2008. The implementation of SFAS No. 159, effective
October 1, 2008, did not have a material effect on the consolidated
financial statements in the December 31, 2008 quarter.




In
December 2007, the FASB issued SFAS No. 141 (revised), “Business
Combinations.” SFAS No. 141(R) changes the accounting for business
combinations including the measurement of acquirer shares issued in
consideration for a business combination, the recognition of contingent
consideration, the accounting for preacquisition gain and loss contingencies,
the recognition of capitalized in-process research and development, the
accounting for acquisition-related restructuring cost accruals, the treatment of
acquisition related transaction costs and the recognition of changes in the
acquirer’s income tax valuation allowance. SFAS No. 141(R) is effective for
fiscal years beginning after December 15, 2008, with early adoption
prohibited. The Company is required to adopt SFAS No. 141(R) effective
October 1, 2009, and it is currently evaluating the effect, if any, on
its results of operations or financial position.




In
December 2007, the FASB issued SFAS No. 160, “Non Controlling
Interests in Consolidated Financial Statements, an amendment of Accounting
Research Bulletin, or ARB No. 51, “Consolidated Financial Statements.” SFAS
No. 160 changes the accounting for non controlling (minority) interests in
consolidated financial statements, including the requirement to classify non
controlling interests as a component of consolidated stockholders’ equity, and
the elimination of “minority interest” accounting in results of operations with
earnings attributable to non controlling interests reported as part of
consolidated earnings. Additionally, SFAS No. 160 revises the accounting
for both increases and decreases in a parent’s controlling ownership interest.
SFAS No. 160 is effective for fiscal years beginning after
December 15, 2008, with early adoption prohibited. The Company is
required to adopt SFAS No. 160 effective October 1, 2009, and it
is currently evaluating the effect, if any, on its results of operations or
financial position.




2.      DEVELOPMENT
AGREEMENTS




The
Company enters into development agreements to provide financing for new gaming
facilities or for the expansion of existing facilities. In return, the facility
dedicates a percentage of its floor space to placement of the Company’s player
terminals, and the Company receives a fixed percentage of those player
terminals’ hold per day over the term of the agreement. The agreements typically
provide for some or all of the advances to be repaid by the customer to the
Company. Amounts advanced in excess of those to be reimbursed by the customer
are allocated to intangible assets and are generally amortized over the life of
the contract, which is recorded as a reduction of revenue generated from the
gaming facility. Certain of the agreements contain player terminal performance
standards that could allow the facility to reduce a portion of the Company’s
floor space. In the past and in the future, the Company may by mutual agreement
and for consideration, amend these contracts to reduce its floor space at the
facilities. Any proceeds received for the reduction of floor space is first
applied as a recovery against the intangible asset or property and development
for that particular development agreement, if any.




The
Company has recently fulfilled a commitment to a significant, existing tribal
customer to provide approximately 43.8%, or $65.6 million, of the
total funding for a facility expansion. Because of the Company’s commitment to
fund the expansion, it secured the right to place an additional
1,400 gaming units in the expanded facility in southern Oklahoma. The
Company recorded all advances as a note receivable and imputed interest on the
interest free loan. The discount (imputed interest) was recorded as contract
rights and will be amortized over the life of the agreement. The repayment
period of the note will be based on the performance of the facility. As of
December 31, 2008, the Company had installed the additional
1,400 units in the expanded facility.


-12-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS – (Continued)
 (Unaudited)




Management
reviews intangible assets related to development agreements for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. There were no events or changes in circumstance
during the three months ended December 31, 2008, which would require
an impairment change to the assets’ carrying value.




The
following net amounts related to advances made under development agreements and
were recorded in the following balance sheet captions:




December 31,
                          2008
                        
                        
                        September 30,
                          2008(In
      thousands)Included
      in:Notes
      receivable, net
                        
                        $
                        60,514
                        
                        
                        $
                        61,750Intangible
      assets – contract rights, net of accumulated amortization
                        
                        
                        28,610
                        
                        
                        
                        29,368








3.      PROPERTY
AND EQUIPMENT AND LEASED GAMING EQUIPMENT




The
Company’s property and equipment and leased gaming equipment consisted of the
following:




December 31,
                      2008
                    
                    
                    September 30,
                      2008
                    
                    Estimated
                      Useful
                      Lives(In
      thousands)Gaming
      equipment and third-party gaming content licenses available for deployment
      (1)
                    
                    $
                    36,480
                    
                    
                    $
                    30,252Deployed
      gaming equipment
                    
                    
                    97,278
                    
                    
                    
                    96,584
                    
                    3-5
      yearsDeployed
      third-party gaming content licenses
                    
                    
                    37,868
                    
                    
                    
                    34,444
                    
                    1.5-3 yearsTribal
      gaming facilities and portable buildings
                    
                    
                    4,720
                    
                    
                    
                    4,720
                    
                    5-7
      yearsThird-party
      software costs
                    
                    
                    7,817
                    
                    
                    
                    7,732
                    
                    3-5
      yearsVehicles
                    
                    
                    3,501
                    
                    
                    
                    3,502
                    
                    3-10
      yearsOther
                    
                    
                    3,162
                    
                    
                    
                    3,191
                    
                    3-7
      yearsTotal
      property and equipment
                    
                    
                    190,826
                    
                    
                    
                    180,425Less
      accumulated depreciation and amortization
                    
                    
                    (115,317
                    )
                    
                    
                    (113,096
                    )Total
      property and equipment, net
                    
                    $
                    75,509
                    
                    
                    $
                    67,329Leased
      gaming equipment
                    
                    $
                    173,384
                    
                    
                    $
                    165,903
                    
                    3
      yearsLess
      accumulated depreciation
                    
                    
                    (132,782
                    )
                    
                    
                    (129,879
                    )Total
      leased gaming equipment, net
                    
                    $
                    40,602
                    
                    
                    $
                    36,024





(1)
              Gaming
      equipment and third-party gaming content licenses begin depreciating when
      they are placed in service.




During
the three months ended December 31, 2008, the Company disposed of or
wrote off $38,000 of third-party gaming content licenses, tribal gaming
facilities and portable buildings, vehicles, deployed gaming equipment, and
other equipment.




Leased
gaming equipment includes player terminals placed under participation
arrangements that are either at customer facilities or in the rental
pool.




In
accordance with SFAS 144, “Accounting for the impairment or Disposal of
Long-Lived Assets,” the Company (i) recognizes an impairment loss only if
the carrying amount of a long-lived asset is not recoverable from its
undiscounted cash flows; and (ii) measures an impairment loss as the
difference between the carrying amount and fair value of the asset. There
were no impairment charges recorded during the three months ended
December 31, 2008.


-13-




MULTIMEDIA
GAMES, INC.
 NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS – (Continued)
 (Unaudited)




4.      INTANGIBLE
ASSETS




The
Company’s intangible assets consisted of the following:




December 31,
                    2008
                  
                  
                  September 30,
                    2008
                  
                  Estimated
                    Useful
                    Lives(In
      thousands)Contract
      rights under development agreements
                  
                  $
                  41,892
                  
                  
                  $
                  41,325
                  
                  5-7
      yearsInternally-developed
      gaming software
                  
                  
                  27,078
                  
                  
                  
                  26,473
                  
                  1-5
      yearsPatents
      and trademarks
                  
                  
                  8,670
                  
                  
                  
                  8,464
                  
                  1-5
      yearsOther
                  
                  
                  1,054
                  
                  
                  
                  1,054
                  
                  3-5
      yearsTotal
      intangible assets
                  
                  
                  78,694
                  
                  
                  
                  77,316Less
      accumulated amortization – all other
                  
                  
                  (42,674
                  )
                  
                  
                  (39,960
                  )Total
      intangible assets, net
                  
                  $
                  36,020
                  
                  
                  $
                  37,356




Contract
rights are amounts allocated to intangible assets for dedicated floor space
resulting from development agreements. For a description of intangible assets
related to development agreements, see “Item 2. Management’s Discussion and
Analysis of Financial Condition and Results of Operations.” The related
amortization expense, or accretion of contract rights, is netted against its
respective revenue category in the accompanying consolidated statements of
operations. In the preceding table, $5.7 million of the $41.8 million
in contract rights is not currently being amortized. The facility was completed
on December 31, 2008. Therefore, the amortization of the contracts
began on January 1, 2009.




Internally
developed gaming software is accounted for under the provisions of SFAS
No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased
or Otherwise Marketed,” and is stated at cost, which is amortized over the
estimated useful life of the software, generally using the straight-line method.
The Company amortizes internally-developed games over a 12 month period,
gaming engines over an 18 month period, gaming systems over a three-year
period and its central management systems over a five-year period. Software
development costs are capitalized once technological feasibility has been
established, and are amortized when the software is placed into service. Any
subsequent software maintenance costs, such as bug fixes and subsequent testing,
are expensed as incurred. Discontinued software development costs are expensed
when the determination to discontinue is made. For the three months ended
December 31, 2008 and 2007, amortization expense related to
internally-developed gaming software was $1.1 million and $716,000,
respectively. During the three months ended December 31, 2008, the
Company wrote off $35,000 related to internally-developed gaming software,
compared to no write off in the same period of 2007.




Management
reviews intangible assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable.




5.      NOTES
RECEIVABLE




The
Company’s notes receivable consisted of the following:




December 31,
                      2008
                    
                    
                    September 30,
                      2008(In
      thousands)Notes
      receivable from development agreements
                    
                    $
                    70,887
                    
                    
                    $
                    72,706Less
      imputed interest discount reclassed to contract rights
                    
                    
                    (10,372
                    )
                    
                    
                    (10,956
                    )Notes
      receivable from equipment sales and other
                    
                    
                    6,861
                    
                    
                    
                    8,012Notes
      receivable, net
                    
                    
                    67,376
                    
                    
                    
                    69,762Less
      current portion
                    
                    
                    (18,688
                    )
                    
                    
                    (23,072
                    )Notes
      receivable – non-current
                    
                    $
                    48,688
                    
                    
                    $
                    46,690








Notes
receivable from development agreements are generated from reimbursable amounts
advanced under development agreements.


-14-


MULTIMEDIA
GAMES, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)




Notes
receivable from equipment sales outstanding as of September 30, 2008
consisted of financial instruments issued by customers for the purchase of
player terminals and licenses, and bore interest at 7.99%. All of the
Company’s notes receivable from equipment sales are collateralized by the
related equipment sold, although the value of such equipment, if repossessed,
may be less than the note receivable outstanding.




6.      CREDIT
FACILITY, LONG-TERM DEBT AND CAPITAL LEASES




The
Company’s Credit Facility, long-term debt and capital leases consisted of the
following:




December 31,
                          2008
                        
                        
                        September 30,
                          2008(In
      thousands)Long-term
      revolving lines of credit
                        
                        $
                        25,222
                        
                        
                        $
                        19,000Term
      loan facility
                        
                        $
                        68,897
                        
                        
                        $
                        67,988Less
      current portion
                        
                        
                        (2,675
                        )
                        
                        
                        (1,544
                        )Long-term
      debt, less current portion
                        
                        $
                        66,222
                        
                        
                        $
                        66,444




Credit
Facility. On April 27, 2007, the Company entered into a
$150 million Revolving Credit Facility which replaced its previous Credit
Facility in its entirety. On October 26, 2007, the Company amended the
Revolving Credit Facility, transferring $75 million of the revolving
credit commitment to a fully funded $75 million term loan due
April 27, 2012. The Term Loan is amortized at an annual amount of
1% per year, payable in equal quarterly installments beginning
January 1, 2008, with the remaining amount due on the maturity date.
The Company entered into a second amendment to the Revolving Credit Facility on
December 20, 2007. The second amendment (i) extended the hedging
arrangement date related to a portion of the term loan to
June 1, 2008; and (ii) modified the interest rate margin
applicable to the Revolving Credit Facility and the term loan.




The
Credit Facility provides the Company with the ability to finance development
agreements and acquisitions and working capital for general corporate purposes.
Amounts under the $75 million revolving credit commitment and
the $75 million term loan mature in five years, and advances under the
term loan and revolving credit commitment bear interest at the Eurodollar rate
plus the applicable spread (7.81% and 8.56%, respectively, as of
December 31, 2008) tied to various levels of interest pricing
determined by total debt to EBITDA.




The
Credit Facility is collateralized by substantially all of the Company’s assets,
and also contains financial covenants as defined in the agreement. These
covenants include (i) a minimum fixed-charge coverage-ratio of not less
than 1.50 : 1.0; (ii) a maximum total debt to EBITDA ratio
of not more than 2.25 : 1.00 through June 30, 2008,
and 1.75 : 1.00 from September 30, 2008 thereafter; and
(iii) a minimum trailing twelve-month EBITDA of not less
than $57 million for the quarter ended September 30, 2007,
and $60 million for each quarter thereafter. As of
December 31, 2008, the Company is in compliance with its loan
covenants. The Credit Facility requires certain mandatory prepayments be made on
the term loan from the net cash proceeds of certain asset sales and condemnation
proceedings (in each case to the extent not reinvested, within certain specified
time periods, in the replacement or acquisition of property to be used in its
businesses). In the second quarter of 2008, the Company made a mandatory
prepayment of the term loan in the amount of $4.5 million due to an early
prepayment of a development agreement note receivable. As of
December 31, 2008, the Credit Facility had availability of
$48.1 million, subject to covenant restrictions.




The
Credit Facility also required that the Company enter into hedging arrangements
covering at least $50 million of the term loan for a three-year period by
June 1, 2008. Therefore, on May 29, 2008, the Company
purchased, for $390,000, an interest rate cap (5% cap rate) covering
$50 million of the term loan. The Company accounts for this hedge in
accordance with SFAS No. 133, “Accounting for Derivative Instruments and
Hedging Activities,” which requires entities to recognize all derivative
instruments as either assets or liabilities in the balance sheet, at their
respective fair values. We record changes on a mark to market basis, changes to
the fair value of the interest rate cap on a quarterly basis. These changes in
fair value are recorded in interest expense in the consolidated statement of
operations.




7.      EARNINGS
(LOSS) PER COMMON SHARE




Earnings
(loss) per common share is computed in accordance with SFAS No. 128,
“Earnings per Share.” Presented below is a reconciliation of net income (loss)
available to common stockholders and the differences between weighted average
common shares outstanding, which are used in computing basic earnings (loss) per
share, and weighted average common and potential shares outstanding, which are
used in computing diluted earnings (loss) per share.


-15-


MULTIMEDIA
GAMES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)
 
 Three months ended
                              December 31,2008
                            
                            
                            2007Income
      (loss) available to common stockholders(in
      thousands)
                            
                            $
                            (5,924
                            )
                            
                            $
                            399Weighted
      average common shares outstanding
                            
                            
                            26,623,573
                            
                            
                            
                            26,254,023Effect
      of dilutive securities:Options
                            
                            
                            —
                            
                            
                            
                            1,126,208Weighted
      average commonand
      potential shares outstanding
                            
                            
                            26,623,573
                            
                            
                            
                            27,380,231Basic
      earnings (loss) per share
                            
                            $
                            (0.22
                            )
                            
                            $
                            0.02Diluted
      earnings (loss) per share
                            
                            $
                            (0.22
                            )
                            
                            $
                            0.01
  The
Company had the following options to purchase shares of common stock that were
not included in the computation of dilutive earnings per share due to the
antidilutive effects:
  Three months ended
                        December 31,2008
                      
                      
                      2007In thousands, except share priceCommon
      Stock Options
                      
                      
                      6,780
                      
                      
                      
                      2,235Range
      of exercise price
                      
                      $
                      1.00-$21.53
                      
                      
                      $
                      7.61-$21.53
  In the
three months ended December 31, 2008, options to purchase
approximately 5.9 million shares of common stock, with exercise prices
ranging from $2.33 to $21.53 per share were not included in the
computation of dilutive earnings per share due to the antidilutive effect, and
approximately 890,000 equivalent shares were not included due to the loss
generated in the current year.
   8.      COMMITMENTS
AND CONTINGENCIES
  Litigation
  The
Company is subject to the possibility of loss contingencies arising in its
business and such contingencies are accounted for in accordance with SFAS
No. 5, “Accounting for Contingencies.” In determining loss contingencies,
the Company considers the possibility of a loss as well as the ability to
reasonably estimate the amount of such loss or liability. An estimated loss is
recorded when it is considered probable that a liability has been incurred and
when the amount of loss can be reasonably estimated.
  Diamond Game
Enterprises, Inc. On November 16, 2004, Diamond Game
Enterprises, Inc., or Diamond Game, filed suit in the State Court in Oklahoma
City, Oklahoma, against the Company, along with others, including Clifton Lind,
Robert Lannert, Gordon Graves, Video Gaming Technologies, Inc., or VGT, and its
president, John Yarbrough, alleging five causes of action: (i) deceptive
trade practices; (ii) unfair competition; (iii) wrongful interference
with business; (iv) malicious wrong / prima facie tort; and
(v) restraint of trade. The case asserts that the Company offered allegedly
illegal Class III games on the MegaNanza® and Reel
Time Bingo® gaming
systems to Native American tribes in Oklahoma. Diamond Game claims that the
offer of these games negatively affected the market for its pull-tab game, Lucky
Tab II. Diamond Game also alleges that our development agreements with
Native American tribes unfairly interfere with the ability of Diamond Game to
successfully conduct its business. Diamond Game is seeking injunctive relief and
unspecified damages in excess of $65 million. Diamond Game’s theories of
recovery include claims for actual, treble and punitive damages, as well as
revenue disgorgement.
  -16-
  MULTIMEDIA
GAMES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)
  Diamond
Game and VGT (and its principals) entered into a confidential settlement
agreement in September 2007. The Company will be given credit for the
actual amount of that settlement should any verdict be entered against the
Company in connection with this case. Two material orders have been issued by
the state trial court in connection with the matter: (i) Diamond Game filed
a motion for partial summary judgment seeking a court ruling on game
classification for MegaNanza and Reel Time Bingo; and (ii) the Company
filed a motion seeking summary judgment based on jurisdictional issues. On
November 29, 2007, the trial court denied the Company’s motion for
summary judgment on the jurisdictional issues, and ruled on Diamond Game’s
motion for partial summary judgment, finding that our MegaNanza and Reel Time
Bingo versions 1.0, 1.1 and 1.2 games are not Class II
games under the Indian Gaming Regulatory Act of 1988, or IGRA, but instead
are Class III games.
  The
court’s ruling stated that it was not binding on our tribal customers and the
Company does not expect any of the Reel Time Bingo games currently in play in
Oklahoma to be removed as a result of the court’s ruling. Other game versions
included in the ruling are not in play in Oklahoma. The court’s rulings are not
dispositive of the case and the opinion has no effect on the right of Native
American tribes to play games offered by us. The trial court granted our motion
for immediate certification of its ruling to the Oklahoma Supreme Court. The
Company sought immediate review of the trial court’s decision. On
February 19, 2008, the Oklahoma Supreme Court denied the Company’s
request for immediate review of the trial court’s decision. The action of the
Oklahoma Supreme Court does not preclude a subsequent appeal of the trial
court’s decision and the Company will continue to assert that the games in
question are legal Class II games, and that game classification cannot be
decided by an Oklahoma State Court. Presently, the parties remain engaged in
pre-trial discovery. The trial court has assigned a jury trial date of
March 23, 2009. The Company continues to vigorously defend itself and
believes that its MegaNanza and Reel Time Bingo versions 1.0, 1.1
and 1.2 games were in fact Class II games. Given the inherent
uncertainties in this litigation, the Company is unable to make any prediction
as to the ultimate outcome.
  Kaw Nation of
Oklahoma. In a related case, the Kaw Nation of Oklahoma, a Native
American Tribe in Oklahoma, filed suit against Diamond Game Enterprises, Inc.
and Oklahoma State Court District Judge Noma Gurich on
October 14, 2008. The Company, along with Clifton Lind, Robert Lannert
and Gordon Graves joined the Kaw Nation as plaintiffs in that lawsuit. The Kaw
Nation claims that the assumption of jurisdiction and determination by Judge
Gurich over the determination of the classification under IGRA of MegaNanza and
Reel Time Bingo, which the Kaw Nation had previously classified as
Class II, violated the Kaw Nation’s sovereign rights, as well as its rights
under IGRA as the primary regulator of gaming on Native American lands and the
Indian Commerce Clause of the Constitution of the United States of America.
Additionally, the Company, Clifton Lind, Robert Lannert and Gordon Graves claim
jointly with the Kaw Nation that in the state court lawsuit, Judge Gurich and
Diamond Game have engaged in joint activity under color of state law, which
violates the plaintiffs’ constitutional and federal statutory rights, including
their rights to free commercial speech and due process of law. The Company,
Clifton Lind, Robert Lannert, Gordon Graves and the Kaw Nation also jointly
contend that Judge Gurich and Diamond Game have engaged in activity that is
prohibited by the Oklahoma State Constitution, which expressly disclaims
jurisdiction over activity occurring on Native American lands. The Kaw Nation,
the Company and the other plaintiffs seek a declaratory judgment against Judge
Gurich, holding that, as a state court judge, Judge Gurich does not have
jurisdiction to determine the classification under IGRA of games being played on
Native American lands. The plaintiffs also seek an injunction against Diamond
Game, enjoining Diamond Game from proceeding in its state court lawsuit. On
November 4, 2008, Diamond Game filed a motion to dismiss the Kaw
Nation lawsuit, alleging that the plaintiffs had failed to state a claim upon
which relief could be granted. On November 13, 2008, plaintiffs filed
an amended complaint, seeking additional relief in the alternative that the
federal court determine the classification of MegaNanza and Reel Time Bingo.
Plaintiffs filed their response in opposition to the motion to dismiss on
November 25, 2008. On December 1, 2008, Diamond Game filed
its motion to dismiss amended complaint, again contending that the plaintiffs
had failed to state a claim upon which relief could be granted, relying in part
upon the federal court’s Order of Remand in the Cory Investments, Ltd. case (see
below).
  On
December 12, 2008 the plaintiffs filed a motion for preliminary
injunction seeking to enjoin any additional action in the state court Diamond
Game litigation pending a full hearing on the merits of the Kaw Nation complaint
in federal district court. On January 16, 2009, the Federal District
Court issued an order granting Diamond Game’s motion to dismiss the Kaw Nation
Case and striking a motion for preliminary injunction filed by the Kaw Nation
and the Company. On January 20, 2009, the Company along with the Kaw
Nation filed a notice of appeal seeking review by the 10th Ciruit
Court of Appeals of the Federal District Court’s Order granting Diamond Game’s
motion to dismiss the plaintiff’s case and striking the plaintiff’s motion for
preliminary injunction.Given the
inherent uncertainties in this litigation, the Company is unable to make any
prediction as to the appeal’s ultimate outcome.
  -17-
  MULTIMEDIA
GAMES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)
  Cory Investments
Ltd.On May 7, 2008, Cory Investments, LTD., or Cory
Investments, filed suit in the state court in Oklahoma City, Oklahoma against
the Company, along with others, including Clifton Lind; Robert Lannert; Gordon
Graves; Video Gaming Technologies, Inc. or VGT and its president, Jon Yarbrough,
and a former VGT representative, John Marley; Worldwide Gaming Technologies, or
WGT; AGS, LLC, d/b/a American Gaming Systems; AGS Partners, LLC; Ronald Clapper,
the owner of WGT, AGS, LLC and AGS Partners; Sierra Design Group; and Bally
Technologies, Inc. The case asserts that the Company offered allegedly illegal
Class III games on the MegaNanza and Reel Time Bingo gaming systems to
Native American tribes in Oklahoma, which had a severely negative impact on Cory
Investments’ market for its legal Class II games. Cory Investments also
alleges that the defendants conspired to drive it and other Class II
competitors out of the Class II market in Oklahoma and other states. In
addition to the conspiracy allegations, Cory Investments alleges six causes of
action: (i) deceptive trade practices; (ii) common law unfair
competition; (iii) wrongful interference with business; (iv) malicious
wrong/prima facie tort; (v) intentional interference with contract; and
(vi) unreasonable restraint of trade. Cory Investments is seeking
unspecified actual and punitive damages and equitable relief.
  The
Company and the other defendants were served with summons and a copy of the
lawsuit during the week of July 21, 2008. The defendants removed the
action to a United States District Court for the Western District of Oklahoma.
Cory Investments filed a motion with the federal court to remand the case back
to the state court. That motion was granted by the federal court on
November 13, 2008, resulting in a transfer of the case back to the
state court. All of the defendants have filed motions to dismiss which are
currently set for hearing before the state court district judge on
March 18, 2009; however, due to scheduling conflicts, that hearing
will likely be postponed The Company believes that the claims of Cory
Investments are without merit and intends to defend the case vigorously. Given
the inherent uncertainties in this litigation, the Company is unable to make any
prediction as to the ultimate outcome.
  International
Gamco. International Gamco, Inc., or Gamco, claiming certain rights in
U.S. Patent No. 5,324,035, or the ‘035 Patent, brought suit against
the Company on May 25, 2004, in the U.S. District Court for the
Southern District of California alleging that the Company’s central determinant
system, as operated by the New York State Lottery, infringes the
‘035 Patent. Gamco claims to have acquired ownership of the
‘035 Patent from Oasis Technologies, Inc., or Oasis, a previous owner of
the ‘035 Patent. In February 2003, Oasis assigned the ‘035 Patent to
International Game Technology, or IGT. Gamco claims to have received a license
back from IGT for the New York State Lottery. The lawsuit claims that the
Company infringed the ‘035 Patent after the date on which Gamco assigned
the ‘035 Patent to IGT.
  Pursuant
to an agreement between the Company and Bally Technologies, Inc., or Bally, the
Company currently sublicenses the right to practice the technology stated in the
‘035 Patent in Native American gaming jurisdictions in the United States.
Bally obtained from Oasis the right to sublicense those rights to the Company,
and that sublicense remains in effect today. Under the sublicense from Bally, in
the event that the Company desires to expand its own rights beyond Native
American gaming jurisdictions, the agreement provides the Company the following
options: (i) to pursue legal remedies to establish its rights independent
of the ‘035 Patent; or (ii) to negotiate directly and enter into
a separate agreement with Oasis for such rights, paying either a specified
one-time license fee per jurisdiction or a unit fee per gaming
machine.
  The
Company has made a number of challenges to Gamco’s standing to sue for
infringement of the ‘035 Patent. On October 15, 2007, pursuant to
an interlocutory appeal, the federal circuit court reversed the district court’s
order refusing to dismiss Gamco’s supplemental and second amended Complaint
against the Company. The federal Circuit Court held that Gamco did not have
sufficient rights in the ‘035 Patent to sue the Company without the
involvement of the patent owner, IGT.
  On
December 4, 2007, Gamco and IGT entered into an Amended and
Restated Exclusive License Agreement whereby IGT granted to Gamco exclusive
rights to the ‘035 Patent in the state of New York and the right to
sue for past infringement of the same. On January 9, 2008, Gamco filed
its third amended complaint for infringement of the ‘035 Patent against the
Company. On January 28, 2008, the Company filed an answer to the
complaint denying liability. The Company also filed a third amended counterclaim
against Oasis, Gamco and certain officers of Gamco, for fraud, promise without
intent to perform, negligent misrepresentation, breach of contract, specific
performance and reformation of contract with regard to the Company’s rights
under the Sublicense Agreement for the ‘035 Patent, as well as for
non-infringement and invalidity of the ‘035 Patent. These parties have
filed a motion to dismiss and a motion for summary judgment as to these claims.
The Company has filed a motion for partial summary judgment on its breach of
contract and specific performance claims seeking to enforce the terms of the
Sublicense Agreement. The Company has also moved for summary judgment on Gamco’s
complaint on the ground that it is a licensee. All motions to dismiss and
motions for summary judgment will be heard by the court on February 26,
2009.
  -18-
  MULTIMEDIA
GAMES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)
  On
January 13, 2009, the court held a Markman hearing to construe the
claims of the ‘035 Patent. The Court also heard argument on the Company’s
motion for partial summary judgment to invalidate all of the means-plus-function
claims of the ‘035 Patent
under 35 U.S.C. § 112¶ 6. On
January 15, 2009, the court issued an order granting Gamco leave to
amend its proposed constructions on the means-plus function claims and setting a
schedule for supplemental briefing on amended claims construction, stating that
none of the structures proposed by Gamco in the claim chart considered by the
court referenced an algorithm that was needed to satisfy federal circuit court
standards. A trial date has not yet been set by the court.
  The
Company continues to vigorously defend this matter. Given the inherent
uncertainties in this litigation, the Company is unable to make any prediction
as to the ultimate outcome.
  NIGC Class II
Game Classification Regulations. On
October 24, 2007, the NIGC published in the Federal Register, four
proposed rules concerning classification standards to distinguish between
Class II games played with technologic aids and Class III facsimiles
of games of chance, a revision of the definition of “electronic or
electromechanical facsimile,” technical standards for Class II gaming and
Class II minimum internal control standards. If the classification
standards and the revised definition of “electronic or electromechanical
facsimile” become final regulations, they will have a material and adverse
economic impact on the Class II gaming market by limiting the use of
Class II electronic technology and severely restricting the manner in which
bingo may be played, thereby making Class II games less attractive to the
customer. On January 15, 2008, the NIGC extended the comment period
for the proposed Class II gaming regulations until March 9, 2008.
However, in May 2008, the Chairman of the NIGC announced that the NIGC
would not move forward with its plans to publish final regulations revising the
definition of “electronic or electromechanical facsimile” and implementing new
Class II gaming classification standards. The NIGC has published
regulations establishing technical standards for Class II electronic gaming
and Class II minimum internal control standards. The standards allow for a
five-year grandfathering moratorium if existing games and systems meet minimum
requirements. The Company is currently submitting games and systems to be
evaluated under the new grandfathering moratorium articulated in
25 CFR 547.4 of the new NIGC technical standards.
  Development
Agreements.In 2004, the Company received a letter from the Acting
General Counsel of the NIGC, dated November 30, 2004, advising the
Company that its agreements with a certain customer may evidence a proprietary
interest by it in a tribe’s gaming activities, in violation of IGRA and the
tribe’s gaming ordinances. The NIGC invited the Company and the tribe to submit
any explanation or information that would establish that the agreements’ terms
do not violate the requirement that tribes maintain sole proprietary interest in
their own gaming operations.
  In a
letter dated November 8, 2007, the Acting General Counsel of the NIGC
reiterated the statements made in her November 30, 2004 letter, that
the NIGC did not then conclude that the agreements with the tribe that it
reviewed constituted management agreements, but that the NIGC was concerned
that, taken together, the agreements demonstrated a proprietary interest, by the
Company, in the tribe’s gaming activity that may be contrary to law. Although
the Company believes that it responded to the NIGC in 2004, explaining why
the agreements did not violate the sole proprietary interest prohibition of IGRA
and did not constitute a management agreement, the November 8, 2007
letter indicated that the NIGC did not receive the written explanation or
further information and requested an explanation. On
December 17, 2007, the Company responded in writing to the NIGC,
correcting the misstatements contained in the NIGC’s 2004 letter. To date,
the Company has received no further communication from the NIGC on this
issue.
  If
certain of the Company’s development agreements are finally determined to be
management contracts or to create a “proprietary” interest of the Company in
tribal gaming operations, there could be material adverse consequences to the
Company. In that event, the Company may be required, among other things, to
modify the terms of such agreements. Such modifications may adversely affect the
terms on which the Company conducts business, and have a significant impact on
the Company’s financial condition and results of operations from such agreements
and from other development agreements that may be similarly interpreted by the
NIGC.
  The
Company’s development agreements could be subject to further review at any time.
Any further review of the Company’s development agreements by the NIGC, or
alternative interpretations of applicable laws and regulations, could require
substantial modifications to the agreements or result in their designation as
“management contracts,” which could materially and adversely affect the terms on
which the Company conducts business.
  -19-
  MULTIMEDIA
GAMES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
 (Unaudited)
  Other Litigation.In addition to the threat of litigation relating to the Class II or
Class III status of the Company’s games and equipment, the Company is the
subject of various pending and threatened claims arising out of the ordinary
course of business. The Company believes that any liability resulting from these
various other claims will not have a material adverse effect on its results of
operations or financial condition or cash flows.
  Other.Existing federal and state regulations may also impose civil and criminal
sanctions for various activities prohibited in connection with gaming
operations, including false statements on applications, and failure or refusal
to obtain necessary licenses described in the regulations.
  -20-
  ITEM
      2.
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
  FUTURE
EXPECTATIONS AND FORWARD-LOOKING STATEMENTS
  This
Quarterly Report and the information incorporated herein by reference contain
various “forward-looking statements” within the meaning of federal and state
securities laws, including those identified or predicated by the words
“believes,” “anticipates,” “expects,” “plans,” “will,” or similar expressions
with forward-looking connotations. Such statements are subject to a number of
risks and uncertainties that could cause the actual results to differ materially
from those projected. Such factors include, but are not limited to, the
uncertainties inherent in the outcome of any litigation of the type described in
this Quarterly Report under “PART II – Item 1. Legal Proceedings,” trends
and other expectations described in “PART I – Item 2. Management’s
Discussion and Analysis of Financial Condition and Results of Operations,” risk
factors disclosed in our earnings and other press releases issued to the public
from time to time, as well as those other factors as described under
“PART II – Item 1A. Risk Factors” set forth below. Given these
uncertainties, readers of this Quarterly Report are cautioned not to place undue
reliance upon such statements. All forward-looking statements in this document
are based on information available to us as of the date hereof, and we assume no
obligations to update any such forward-looking statements.
  Overview
  We are a
developer and distributor of comprehensive systems, content, electronic games
and gaming player terminals for the casino, charity, international bingo, and
video lottery markets. Initially, our customers were located primarily in the
Native American gaming sector; however, around 2003, we began diversifying
into broader domestic and international gaming markets.
  Although
we continue to develop systems and products for Native American tribes
throughout the United States, we now intend to expand our efforts to include the
development and marketing of products and services: (i) for the various
commercial casino markets; (ii) video lottery systems and other products
for various domestic and international lotteries; and (iii) products for
various charity and international bingo and other emerging markets.
  Our
products cover a broad spectrum of the gaming industry, including: interactive
systems for both server-based and stand-alone gaming operations; interactive
electronic bingo games for the Class II gaming market and for the
Class III, stand-alone and video lottery markets; proprietary gaming player
terminals in multiple configurations and formats; electronic instant lottery
scratch ticket systems; casino management systems, including player tracking,
cash and cage, slot accounting, and slot management modules; unified currency
systems; and other electronic and paper bingo systems. In addition, we provide
maintenance, operations support and other services for our customers and
products.
  We design
and develop networks, software and content that provide our customers with,
among other things, comprehensive gaming systems, some of which are delivered
through a telecommunications network that links our player terminals with one
another, both within a single gaming facility or among several gaming
facilities.
  We derive
the majority of our gaming revenue from participation (revenue sharing)
agreements, pursuant to which we place systems, player terminals, proprietary
and licensed content operated on player terminals, and back-office systems and
equipment (collectively referred to as gaming systems) into gaming facilities.
To a lesser degree, we earn revenue from the sale or placement of gaming systems
(e.g., the opening of a new casino, or a change in the law that allows existing
casinos to increase the number of player terminals permitted under prior law) on
a lease-purchase or participation basis and from the back-office fees generated
by video lottery systems, principally in the Washington State, Class III
market. We also generate gaming revenue as consideration for providing the
central determinant system for a network of player terminals operated by the New
York State Division of the Lottery. In addition, we earn a small portion of our
revenue from the sale of lottery systems and the placement of nontraditional
gaming products, such as electronic scratch tickets, sweepstakes, or linked
interactive paper bingo systems. Recently, we entered the international
electronic bingo market and currently supply bingo systems to three customers in
Mexico, whereby we receive fees based on the net earnings of each system. During
fiscal 2009, we intend to generate revenue from the sale of non-linked
Class III player terminals to Class III Native American
markets.
  -21-
  Class II
Market
  We derive
our Class II gaming revenues from participation arrangements with our
Native American customers. Under these arrangements, we retain ownership of the
gaming equipment installed at our customers’ tribal gaming facilities, and
receive revenue based on a percentage of the hold per day generated by each
gaming system. Our portion of the hold per day is reported by us as “Gaming
revenue – Class II” and represents the total amount that end users wager,
less the total amount paid to end users for prizes, the amounts retained by the
facilities for their share of the hold and the accretion of contract
rights.
  As the
Class II market has matured, we have seen new competitors with significant
gaming experience and financial resources enter the market. New tribal-state
compacts, such as the Oklahoma gaming legislation passed by referendum
in 2004, have also led to increased competition. In addition, there has
been what we believe to be an extended period of non enforcement by regulators
of existing restrictions on non-Class II devices, which has forced us to
continue competing against games that do not appear to comply with the published
regulatory restrictions on Class II games. Due to this increased
competition in Oklahoma, and because of continued conversion to games played
under the compact, we have and may continue to experience pressure on our
pricing model and hold per day, with the result that gaming providers, including
the Company, are competing on the basis of price as well as the entertainment
value and technological quality of their products. We have also experienced and
expect to continue to experience a decline in the number of our Class II
games deployed in Oklahoma, in accordance with our recent conversion strategy.
While we will continue to compete by regularly introducing new and more
entertaining games with technological enhancements that we believe will appeal
to end users, we believe that the level of revenue retained by our customers
from their installed base of player terminals will become a more significant
competitive factor, one that may require us to change the terms of our
participation arrangements with customers. We will continue the deployment of
one-touch, compact-compliant Class III games in Oklahoma, which will reduce
the number of Class II machines in play.
  Class III
Games and Systems for Oklahoma
  During 2004,
the Oklahoma Legislature passed legislation authorizing certain forms of gaming
at racetracks, and additional types of games at tribal gaming facilities,
pursuant to a tribal-state compact. The Oklahoma gaming legislation allows the
tribes to sign a compact with the state of Oklahoma to operate an unlimited
number of electronic instant bingo games, electronic bonanza-style bingo games,
electronic amusement games, and non-house-banked tournament card games. In
addition, certain horse tracks in Oklahoma are allowed to operate a limited
number of instant and bonanza-style bingo games and electronic amusement games.
All vendors placing games at any of the racetracks under the compact will
ultimately be required to be licensed by the state of Oklahoma. Pursuant to the
compacts, vendors placing games at tribal facilities will have to be licensed by
each tribe. All electronic games placed under the compact have to be certified
by independent testing laboratories to meet technical specifications. These
technical specifications were published by the Oklahoma Horse Racing Commission
and the individual tribal gaming authorities in the first calendar quarter
of 2005. We are fully licensed in Oklahoma and as of
December 31, 2008, we had placed 6,555 player terminals at
42 facilities that are operating under the Oklahoma gaming compact. We
generally receive a 20% revenue share for the games played under the
Oklahoma Gaming Compact.
  Class III
Games and Systems for Native American and Commercial Casino Markets
  During
fiscal 2007, we began designing and developing stand-alone Class III
player terminals to be sold or placed on a revenue share basis in the large and
broad Class III stand-alone gaming market for Native American casinos as
well as domestic and international commercial casinos. All player terminals
delivered to these markets will have to receive specific jurisdictional
approvals from the appropriate testing laboratory and from the appropriate
regulatory agency. Our first group of stand-alone player terminals has been
placed in the Class III stand-alone market in Rhode Island. We believe that
we will deliver additional player terminals to other Class III markets this
fiscal year. We believe that additions to our key senior management personnel
will help accelerate our entrance into new Class III markets.
  Charity
Market
  Charity
bingo and other forms of charity gaming are operated by or for the benefit of
non profit organizations for charitable, educational and other lawful purposes.
These games are typically only interconnected within the gaming facility where
the terminals are located. Regulation of charity gaming is vested with each
individual state, and in some states, regulatory authority is delegated to
county or municipal governmental units. In Alabama, our largest charity market,
constitutional amendments have been passed authorizing charity bingo in certain
locations. The regulation of charity bingo in Alabama is typically vested with a
local governmental authority. However, the Governor’s office has commissioned a
task force to review the types of games placed in the charitable bingo halls in
the state. We ordinarily place player terminals under participation arrangements
in the charity market and receive a percentage of the hold per day generated by
each of the player terminals. As of December 31, 2008, we had
2,379 high-speed, standard bingo games installed for the charity market in
three Alabama facilities.
  -22-
  All
Other Gaming Markets
  Class III
Washington State Market.The majority of our
Class III gaming equipment in Washington State has been sold to customers
outright, for a one-time purchase price, which is reported in our results of
operations as “Gaming equipment, system sale and lease revenue” at the time of
proper revenue recognition. Certain game themes we use in the Class III
market have been licensed from third parties and are resold to customers along
with our Class III player terminals. Historically, revenue from the sale of
Class III gaming equipment is recognized when the units are delivered to
the customer, and the licensed games installed, or over the contract term when
the fair value of undelivered products has not been established. Because we sell
new products, systems and services for which fair value has not been
established, beginning in fiscal 2008, revenue generated from this market
will generally be recognized over the terms of the contracts. To a considerably
lesser extent, we also enter into either participation arrangements or
lease-purchase arrangements for our Class III player terminals, on terms
similar to those used for our player terminals in the Class II
market.
  We also
receive a small back-office fee from both leased and sold gaming equipment in
Washington State. Back-office fees cover the service and maintenance costs for
back-office servers installed in each facility to run our Class III games,
as well as the cost of related software updates.
  State Video
Lottery Market. In January 2004, we installed our central
determinant system for the video lottery terminal network that the New York
Lottery operates at licensed New York State racetrack casinos. As payment for
providing and maintaining the central determinant system, we receive a small
portion of the network-wide hold per day. Our contract with the New York Lottery
provides for a three-year term with an additional three one-year automatic
renewal under certain conditions. We are seeking to take advantage of the
recently passed legislation in New York State that allows the New York Lottery
to extend its vendor contracts at its sole discretion, notwithstanding the
automatic renewal provision. We are working to significantly extend the current
contract which is set to expire in 2010.
  International
Commercial Bingo Market. In March 2006, we entered into a contract
with Apuestas Internacionales, S.A. de C.V., or Apuestas, a subsidiary
of Grupo Televisa, S.A., to provide traditional and electronic bingo
gaming, technical assistance, and related services for Apuestas’ locations in
Mexico. Apuestas currently has a permit issued by the Mexican Ministry of the
Interior (Secretaria de Gobernación) to open and operate 65 bingo parlors.
Apuestas is projecting that all 65 bingo parlors will be open by
May 2011. As of December 31, 2008, we had installed
4,898 player terminals at 21 bingo parlors in Mexico under this
contract with Apuestas. At December 31, 2008, all player terminals
placed by us in the Apuestas bingo parlors were pursuant to a revenue share
arrangement that is comparable to our Oklahoma market arrangements.
  As of
December 31, 2008, we had entered into separate contracts with four
other companies incorporated in Mexico to provide traditional and electronic
bingo gaming, technical assistance, and related services for bingo parlors in
Mexico. As of December 31, 2008, we had installed 590 player
terminals at four parlors in Mexico under these contracts.
  Development
Agreements
  As we
seek to continue the growth in our customer base and to expand our installed
base of player terminals, a key element of our strategy has become entering into
development agreements with various Native American tribes to assist in the
funding of new or expansion of existing tribal gaming facilities. Pursuant to
these agreements, we advance funds to the tribes for the construction of new
tribal gaming facilities or for the expansion of existing
facilities.
  Amounts
advanced that are in excess of those to be reimbursed by such tribes for real
property and land improvements are allocated to intangible assets and are
generally amortized over the life of the contract on a straight-line
basis.
  -23-
  In return
for the amounts advanced by us, we receive a commitment for a fixed number of
player terminal placements in the facility or a fixed percentage of the
available gaming floor space, and a fixed percentage of the hold per day from
those terminals over the term of the development agreement. Certain of the
agreements contain player terminal performance standards that could allow the
facility to reduce a portion of our floor space. In addition, certain
development agreements allow the facilities to buy out floor space after
advances that are subject to repayment have been repaid.
  We have
in the past, and may in the future, reduce the number of player terminals in
certain of our facilities as a result of ongoing competitive pressures faced by
our customers from alternative gaming facilities and pressures faced by our
machines from competitors’ products. We have in the past, and in the future may
also, by mutual agreement and for consideration, amend these contracts in order
to reduce the number of player terminals at these facilities.
  We have
recently fulfilled a commitment to a significant, existing Oklahoma tribal
customer to provide approximately 43.8%, or $65.6 million, of the
total funding for a facility expansion. Because of our commitment to fund the
expansion, we secured the right to place an additional 1,400 gaming units
in the expanded facility in southern Oklahoma. We recorded all advances as a
note receivable and imputed interest on the interest free loan. The discount
(imputed interest) was recorded as contract rights and will be amortized over
the life of the agreement. The repayment period of the note will be based on the
performance of the facility. As of December 31, 2008, the Company had
installed the additional 1,400 units.
  As a
result of the substantial levels of past and current development activity in
Oklahoma, we expect the future pace of development in Oklahoma to decline
somewhat. Accordingly, we do not anticipate future levels of development
participation in Oklahoma to keep pace with our historical levels. As of
December 31, 2008, we have placed approximately 5,400 units
in 10 facilities in Oklahoma pursuant to development
agreements.
  Third-Party
Software and Technology
  Our
Manufacturing and License Agreement with WMS Gaming, Inc., which was originally
entered into on May 17, 2004 and amended and restated on
June 29, 2005 (the “Agreement”), will expire under operation of its
terms on June 30, 2009. The Agreement enabled us to distribute, at a
discount, WMS licensed products (i) on an exclusive (except as to WMS)
basis in the Class II and Class III Native American market in
Oklahoma; (ii) on a limited exclusive basis (except as to WMS and subject
to WMS’ existing commitments) in the Class II Native American market in
North America, the pull tab and Class II-style bingo market in Mexico, and
in the Charity markets in Alabama; and (iii) on a non exclusive basis for
the Class III market in Washington. Although we may exercise certain
sell-off rights in Oklahoma and Mexico, after June 30, 2009, we
may continue to distribute WMS products, but without the benefits of a
contractual discount or a grant of exclusivity.
   -24-
  RESULTS
OF OPERATIONS
  The
following tables outline our end-of-period and average installed base of player
terminals for the three months ended December 31, 2008
and 2007.
  At December 31,2008
                    
                    
                    2007End-of-period
      installed player terminal baseClass II
      player terminalsNew
      Generation system - Reel Time Bingo®
                    
                    
                    2,211
                    
                    
                    
                    3,477Legacy
      system
                    
                    
                    303
                    
                    
                    
                    342Oklahoma
      compact games
                    
                    
                    6,555
                    
                    
                    
                    4,369Mexico
                    
                    
                    5,488
                    
                    
                    
                    3,513Other
      player terminals(1)
                    
                    
                    2,681
                    
                    
                    
                    2,729
 
 Three Months Ended
                      December 31,2008
                    
                    
                    2007Average
      installed player terminal base:Class II
      player terminalsNew
      Generation System - Reel Time Bingo
                    
                    
                    2,209
                    
                    
                    
                    3,691Legacy
      system
                    
                    
                    303
                    
                    
                    
                    346Oklahoma
      compact games
                    
                    
                    5,902
                    
                    
                    
                    4,190Mexico
                    
                    
                    5,369
                    
                    
                    
                    3,114Other
      player terminals(1)
                    
                    
                    2,703
                    
                    
                    
                    2,737
 
 (1) Other
player terminals include charity, Rhode Island Lottery and Malta.
  Three
Months Ended December 31, 2008, Compared to Three Months Ended
December 31, 2007
  Total
revenues for the three months ended December 31, 2008, were
$28.6 million, compared to $30.2 million for the three months
ended December31 2007, a $1.6 million or 5%
decrease.
  Gaming
Revenue – Class II
  §
                Class II
      gaming revenue was $5.0 million in the three months ended
      December 31, 2008, compared to $8.0 million in the three
      months ended December 31, 2007, a $3.0 million or
      38% decrease. We expect the number of Class II terminals to
      continue to decrease as they are replaced with higher-earning Oklahoma
      compact player terminals.
 §
                Reel
      Time Bingo revenue was $4.5 million for the three months ended
      December 31, 2008, compared to $7.4 million in the three
      months ended December 31, 2007, a $2.9 million or 39%
      decrease. The average installed base of player terminals
      decreased 40%, which was partially offset by a 10% increase in
      the average hold per day. Accretion of contract rights related to
      development agreements, which is recorded as a reduction of revenue,
      decreased $72,000 or 21%, to $278,000 in the three months
      ended December 31, 2008, compared to $350,000 in the
      three months ended December 31, 2007. The reduction in accretion
      of contract rights is the result of allocating the total accretion rights
      across all product lines with the majority being allocated against
      Oklahoma compact revenue. During fiscal 2009, we will continue to
      convert Reel Time Bingo player terminals to games played under the
      compact, which are included in “Gaming revenue – Oklahoma compact,” and we
      expect this trend to continue in the future as Reel Time Bingo competes
      with the higher hold per day of compact games.
 §
              Legacy
      revenue decreased $118,000, or 19%, to $500,000 in the
      three months ended December 31, 2008, from $618,000 in the
      three months ended December 31, 2007. The average installed base
      of Legacy player terminals decreased 12%, and the hold per day
      decreased by 10%.
  -25-
  Gaming
Revenue – Oklahoma Compact
  §
              In
      March 2005, we began converting Reel Time Bingo player terminals to
      games that could be played under the Oklahoma compact. The Oklahoma
      compact games generated revenue of $13.8 million in the three months
      ended December 31, 2008, compared to $11.6 million during
      the same period of 2007, an increase of $2.2 million,
      or 19%. The average installed base of the Oklahoma compact games
      increased 40%, as the conversion of Class II player terminals to
      compact games continues, while hold per day decreased 11%. We expect
      the rate of conversion from Class II to compact games to decline in
      the future, as over 86% of the Oklahoma installed base at
      December 31, 2008, consisted of Oklahoma compact units.
      Accretion of contract rights related to development agreements, which is
      recorded as a reduction of revenue, increased $402,000, or 65%, to
      $1.0 million, in the three months ended December 31, 2008,
      compared to $621,000 in the same period
  of 2007.
  Gaming
Revenue – Charity
  §
              Charity
      gaming revenues decreased $1.3 million, or 34%, to
      $2.5 million for the three months ended December 31, 2008,
      compared to $3.9 million for the same period of 2007. The
      average installed base of charity player terminals decreased 6%, and
      the hold per day decreased 32%. The decrease in the hold per day is
      primarily attributable to competitive factors and to a lesser extent,
      economic factors. Competitive factors would include, but not be limited
      to, a significant increase of competitor units added to the gaming floor
      of our largest charity operation, players reward programs not offered on
      our player terminals and location of our player terminals on the gaming
      floor.
  Gaming
Revenue – All Other
  §
                Class III
      back-office fees decreased $107,000, or 12%, to $774,000 in
      the three months ended December 31, 2008, from $881,000 during
      the same period of 2007.
 §
                Revenues
      from the New York Lottery system increased $87,000, or 6%, to
      $1.6 million in the three months ended December 31, 2008,
      from $1.5 million in the three months ended
      December 31, 2007. Currently, eight of the nine planned
      racetrack casinos are operating, with approximately 13,000 total
      terminals. At the current placement levels, we have obtained near
      break-even operations for the New York Lottery system and expect to
      achieve profitable operations after all of the facilities are
      operating.
 §
              Revenues
      from the Mexico bingo market increased $264,000 to $2.4 million
      in the three months ended December 31, 2008,
      from $2.1 million during the same period of 2007. As of
      December 31, 2008, we had installed 5,448 player terminals
      at 25 bingo parlors in Mexico compared to 3,513 terminals
      installed at 14 bingo parlors at December 31, 2007. Our
      revenue share is in the range of the other electronic bingo markets in
      which we operate.
  Gaming
Equipment and System Sale and Lease Revenue and Cost of Sales
  §
              Gaming
      equipment and system sale and lease revenue was $1.8 million for the
      three months ended December 31, 2008, and for the same period
      of 2007. Gaming equipment and system sale revenue of
      $1.7 million for the three months ended December 31, 2008,
      includes 100 player terminals sold. Gaming equipment and system sale
      revenue of $1.1 million for the three months ended
      December 31, 2007, included the sale of 50 player terminals
      and one system. License revenues for the three months ended
      December 31, 2008, were $77,000, compared to $464,000
      for the three months ended December 31, 2007, a decrease
      of $387,000. Total cost of sales, which includes cost of royalty
      fees, increased $1.1 million, to $1.8 million in the
      three months ended December 31, 2008, from $790,000 in
      the three months ended December 31, 2007. The increase primarily
      relates to the increase in cost of sales associated with the revenue
      discussed above.
  Other
Revenue
  §
              Other
      revenues increased $156,000, or 42%, to $524,000 for
      the three months ended December 31, 2008, from $368,000
      during the same period of 2007. The increase is primarily due to
      increased maintenance income in the three months ended
      December 31, 2008.
  Selling,
General and Administrative Expenses
  §
              Selling,
      general and administrative expenses, or SG&A, increased approximately
      $4.2 million, or 26%, to $20.3 million for the three months
      ended December 31, 2008, from $16.1 million in the same
      period of 2007. This increase was primarily a result of (i) an
      increase in salaries and wages and the related employee benefits of
      approximately $900,000, due to headcount increases (at
      December 31, 2008, we employed 500 full-time and part-time
      employees, compared to 442 at December 31, 2007); and
      (ii) an increase in legal and professional fees of approximately
      $3.1 million, largely related to the Diamond Game legal
      matter.
  -26-
  Amortization
and Depreciation
  §
              Amortization
      expense increased $186,000, or 15%, to $1.4 million for the
      three-months ended December 31, 2008, compared to
      $1.2 million for the same period of 2007. Depreciation expense
      increased $2.2 million, or 19%, to $13.5 million for the
      three months ended December 31, 2008,
      from $11.3 million for the corresponding three months ended
      December 31, 2007, primarily as a result of additional player
      terminals for the Oklahoma market.
  Other
Income and Expense
  §
                Interest
      income increased $156,000, or 14%, to $1.3 million for the three
      months ended December 31, 2008, from $1.1 million in the
      same period of 2007. We entered into development agreements with a
      customer under which approximately $70.9 million has been advanced
      and is outstanding at December 31, 2008, and for which we impute
      interest on these interest-free loans. For the three months ended
      December 31, 2008, we recorded imputed interest of
      $1.2 million million relating to development agreements with an
      imputed interest rate range of 6.00% to 9.00%, compared to
      $804,000 for the three months ended
      December 31, 2007.
 §
                Interest
      expense for each of the three months ended December 31, 2008
      and 2007 was $2.1 million. During April 2007, we entered
      into a $150 million Revolving Credit Facility which replaced our
      previous Credit Facility in its entirety. On October 26, 2007,
      we amended the Revolving Credit Facility, transferring $75 million of
      the revolving credit commitment to a fully funded $75 million term
      loan. We entered into a second amendment to the Revolving Credit Facility
      on December 20, 2007. The second amendment (i) extended the
      hedging arrangement date related to a portion of the term loan to
      June 1, 2008; and (ii) modified the interest rate margin
      applicable to the Revolving Credit Facility and the term
    loan.
 §
              Other
      income decreased $264,000, or 78%, to $74,000 for the three
      months ended December 31, 2008, compared to $338,000 in the same
      period of 2007. Other income primarily decreased due to the last
      distribution from a partnership
interest.
  Income
tax benefit increased by $3.0 million to $3.2 million for the
three months ended December 31, 2008, from an income tax benefit of
$246,000 in the same period of 2007. These figures represent effective
income tax rates of 35% and (160.8)% for the three months ended
December 31, 2008 and 2007, respectively. The effective tax rate
has been impacted by the tax treatment of stock compensation expense. To the
extent that the Company experiences volatility in tax deductibility of certain
stock compensation expense, there will remain volatility in the effective tax
rate.
  RECENT
ACCOUNTING PRONOUNCEMENTS
  We
monitor new, generally accepted accounting principle and disclosure reporting
requirements issued by the Securities and Exchange Commission, or SEC, and other
standard setting agencies. Recently issued accounting standards affecting our
financial results are described in Note 1 of our unaudited condensed
consolidated financial statements.
  CRITICAL
ACCOUNTING POLICIES AND ESTIMATES
  We
prepare our consolidated financial statements in conformity with accounting
principles generally accepted in the United States. As such, we are required to
make certain estimates, judgments and assumptions that we believe are reasonable
based on the information available. These estimates and assumptions affect the
reported amounts of assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the periods
presented. There can be no assurance that actual results will not differ from
those estimates. We believe the following represent our most critical accounting
policies.
  Management
considers an accounting estimate to be critical if:
  §
              it
      requires assumptions to be made that were uncertain at the time the
      estimate was made, and
  §
              changes
      in the estimate or different estimates that could have been selected could
      have a material impact on our consolidated results of operation or
      financial condition.
  -27-
  Revenue
Recognition.As further discussed in the discussion of our revenue
recognition policy in Note 1 of our consolidated financial statements,
revenue from the sale of software is accounted for under Statement of
Position 97-2, “Software Revenue Recognition,” or SOP 97-2, and its various
interpretations. If Vendor-Specific Objective Evidence, or VSOE, of fair value
does not exist, the revenue is deferred until such time that all elements have
been delivered or services have been performed. If any element is determined to
be essential to the function of the other, revenues are generally recognized
over the term of the services that are rendered. In those limited situations
where VSOE does not exist for any undelivered elements of a multiple element
arrangement, then the aggregate value of the arrangement, including the value of
products and services delivered or performed, is initially deferred until all
hardware and software is delivered, and then is recognized ratably over the
period of the last deliverable, generally the service period of the contract.
Depending upon the elements and the terms of the arrangement, we recognize
certain revenues under the residual method. Under the residual method, revenue
is recognized when VSOE of fair value exists for all of the undelivered
elements in the arrangement, but does not exist for one or more of the delivered
elements in the arrangement. Under the residual method, we defer the fair value
of undelivered elements, and the remainder of the arrangement fee is then
allocated to the delivered elements and is recognized as revenue, assuming the
other revenue recognition criteria are met.
  Assumptions/Approach
Used: The
determination whether all elements of sale have VSOE is a subjective measure,
where we have made determinations about our ability to price certain aspects of
transactions.
  Effect
if Different Assumptions Used: When we have determined
that VSOE does not exist for any undelivered elements of an arrangement, then
the aggregate value of the arrangement, including the value of products and
services delivered or performed, is initially deferred until all products or
services are delivered, and then is recognized ratably over the period of the
last deliverable, generally the service period of the contract. The deferral of
revenue under arrangements where we have determined that VSOE does not exist has
resulted in $9.1 million being recorded as deferred revenue at
December 31, 2008. If we had made alternative assessments as to the
existence of VSOE in these arrangements, some or all of these amounts could have
been recognized as revenue prior to December 31, 2008.
  Share-Based
Compensation Expense. Effective October 1, 2005, we adopted the
fair value recognition provisions of SFAS 123(R), using the modified prospective
transition method, and therefore have not restated prior periods’ results. Under
this method, we recognize compensation expense for all share-based payments
granted after October 1, 2005 and prior to but not yet vested as of
October 1, 2005, in accordance with SFAS 123(R). Under the fair
value recognition provisions of SFAS 123(R), we recognize share-based
compensation net of an estimated forfeiture rate, and only recognize
compensation cost for those shares expected to vest on a straight-line basis
over the service period of the award. Prior to SFAS 123(R) adoption, we
accounted for share-based payments under APB No. 25, and accordingly
generally recognized compensation expense only if options were granted to
outside consultants with a discounted exercise price.
  Assumptions/Approach
Used: Determining the appropriate fair value model and calculating the
fair value of share-based payment awards requires the input of highly subjective
assumptions, including the expected life of the share-based payment awards, and
stock price volatility. Management determined that volatility is based on
historical volatility trends.  In addition, we are required to estimate the
expected forfeiture rate, and only recognize expense for those shares expected
to vest. If our actual forfeiture rate is materially different from our
estimate, the share-based compensation expense could be significantly different
from what we have recorded in the current period.
  Effect
if Different Assumptions Used: The assumptions used in calculating the
fair value of share-based payment awards, along with the forfeiture rate
estimation, represent management’s best estimates, but these estimates involve
inherent uncertainties and the application of management’s judgment. As a
result, if factors change and we use different assumptions, our stock-based
compensation expense could be materially different in the future.
  Property and
Equipment and Leased Gaming Equipment.Property and equipment and leased
gaming equipment is stated at cost. The cost of property and equipment and
leased gaming equipment is depreciated over their estimated useful lives,
generally using the straight-line method for financial reporting, and regulatory
acceptable methods for tax reporting purposes. Player terminals placed with
customers under participation arrangements are included in leased gaming
equipment. Leased gaming equipment includes a “pool” of rental terminals, i.e.,
the “rental pool.” Rental pool units are those units that have previously been
placed in the field under participation arrangements, but are currently back
with us being refurbished and/or awaiting redeployment. Routine maintenance of
property and equipment and leased gaming equipment is expensed in the period
incurred, while major component upgrades are capitalized and depreciated over
the estimated useful life (Critical Assumption #1) of the component. Sales and
retirements of depreciable property are recorded by removing the related cost
and accumulated depreciation from the accounts. Gains or losses on sales and
retirements of property are reflected in our results of operations.
  Management
reviews long-lived asset classes for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. (Critical Assumption #2)
  -28-
  Assumptions/Approach
used for Critical Assumption #1: The carrying value of the asset is
determined based upon management’s assumptions as to the useful life of the
asset, where the assets are depreciated over the estimated life on a straight
line basis, and where the useful life of items in the rental pool has been
determined by management to be three years.
  Effect
if different assumptions used for Critical Assumption #1: While we
believe that the useful lives that have been determined for our fixed assets are
reasonable, different assumptions could materially affect the carrying value of
the assets, as well as the depreciation expense recorded in each respective
period related to those assets. During the quarter ended
December 31, 2008, a significant portion of the $14.9 million of
depreciation and amortization expense related to assets in the rental pool. If
the depreciable life of assets in our rental pool were changed from three years
to another period of time, we could incur a materially different amount of
depreciation expense during the period.
  Assumptions/Approach
used for Critical Assumption #2: Recoverability of assets to be held and
used is measured through considerations of the future undiscounted cash flows
expected to be generated by the assets as a group, as opposed to analysis by
individual asset, or assets in place at a specific location. If such assets are
considered to be impaired, the impairment recognized is measured by the amount
by which the carrying amount of the assets exceeds their fair value. Assets to
be disposed of are reported at the lower of the carrying amount or the fair
value less costs of disposal. The carrying value of the asset is determined
based upon management’s assumptions as to the useful life of the asset, where
the assets are depreciated over the estimated life on a straight-line
basis.
  Effect
if different assumptions used for Critical Assumption #2: Impairment
testing requires judgment, including estimations of useful lives of the assets,
estimated cash flows, and determinations of fair value. While we believe our
estimates of useful lives and cash flows are reasonable, different assumptions
could materially affect the measurement of useful lives, recoverability and fair
value. If actual cash flows fall below initial forecasts, we may need to record
additional amortization and/or impairment charges. Additionally, while we
believe that analysis of the recoverability of assets in our rental pool is
accurately assessed from a homogenous level due to the interchangeability of
player stations and parts, if these assets were to be reviewed for impairment
using another approach, there could be different outcomes to any impairment
analysis performed.
  Development
Agreements. We enter into development agreements to provide financing for
new gaming facilities or for the expansion of existing facilities. In return,
the facility dedicates a percentage of its floor space to exclusive placement of
our player terminals, and we receive a fixed percentage of those player
terminals’ hold per day over the term of the agreement. Certain of the
agreements contain player terminal performance standards that could allow the
facility to reduce a portion of our guaranteed floor space. In addition, certain
development agreements allow the facilities to buy out floor space after
advances that are subject to repayment have been repaid. The agreements
typically provide for a portion of the amounts retained by the gaming facility
for their share of the hold to be used to repay some or all of the advances
recorded as notes receivable. Amounts advanced in excess of those to be
reimbursed by the customer for real property and land improvements are allocated
to intangible assets and are generally amortized over the life of the contract,
using the straight-line method of amortization (Critical Assumption #1),
which is recorded as a reduction of revenue generated from the gaming facility.
In the past and in the future, we may by mutual agreement and for consideration,
amend these contracts to reduce our floor space at the facilities. Any proceeds
received for the reduction of floor space is first applied against the
intangible asset for that particular development agreement, if any.
  Management
reviews intangible assets related to development agreements for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable (Critical Assumption #2). For the
three-months ended December 31, 2008, there was no impairment to the
assets’ carrying values.
  Assumptions/Approach
used for Critical Assumption #1:Amounts advanced in excess
of those to be reimbursed by the customer for real property and land
improvements are allocated to intangible assets and are generally amortized over
the life of the contract, using the straight-line method of amortization, which
is recorded as a reduction of revenue generated from the gaming facility. We use
a straight-line amortization method, as a pattern of future benefits cannot be
readily determined.
  Effect
if Different Assumptions used for Critical Assumption #1:While we believe that the
use of the straight-line method of amortization is the best way to account for
the costs associated with the costs of acquiring exclusive floor space rights at
our customers facilities, the use of an alternative method could have a material
effect on the amount recorded as a reduction to revenue in the current reporting
period.
  -29-
  Assumptions/Approach
used for Critical Assumption #2: We estimate cash flows directly
associated with the use of the intangible assets to test recoverability and
remaining useful lives based upon the forecasted utilization of the asset and
expected product revenues. In developing estimated cash flows, we incorporate
assumptions regarding future performance, including estimations of hold per day
and estimated units. When the carrying amount exceeds the undiscounted cash
flows expected to result from the use and eventual disposition of the asset, we
then compare the carrying amount to its current fair value. We recognize an
impairment loss if the carrying amount is not recoverable and exceeds its fair
value.
  Effect
if Different Assumptions used for Critical Assumption #2:Impairment testing requires
judgment, including estimations of cash flows, and determinations of fair value.
While we believe our estimates of future revenues and cash flows are reasonable,
different assumptions could materially affect the measurement of useful lives,
recoverability and fair value. If actual cash flows fall below initial
forecasts, we may need to record additional amortization and/or impairment
charges.
  Income
Taxes. In accordance with SFAS, No. 109, we have recorded a
deferred tax assets and liabilities to account for the expected future tax
benefits and consequences of events that have been recognized in our financial
statements and our tax returns. There are several items that result in deferred
tax asset and liability impact to the balance sheet. If we conclude that it is
more likely than not that some portion or all of the deferred tax assets will
not be realized under accounting standards, it is reduced by a valuation
allowance to remove the benefit of recovering those deferred tax assets from our
financial statements. Additionally, in accordance with FIN 48, we have
recorded a liability of $295,000 associated with uncertain tax positions.
FIN 48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. We are required to determine whether it is
more likely than not (a likelihood of more than 50%) that a tax position will be
sustained upon examination, including resolution of any related appeals or
litigation processes, based on the technical merits of the position in order to
record any financial statement benefit. If that step is satisfied, then we must
measure the tax position to determine the amount of benefit to recognize in the
financial statements. The tax position is measured at the largest amount of
benefit that is greater than 50% likely of being realized upon ultimate
settlement.
  Assumptions/Approach
Used: Numerous
judgments and assumptions are inherent in the determination of future taxable
income and tax return filing positions that we take, including factors such as
future operating conditions.
  Effect
if Different Assumptions Used:Management, along with
consultation from an independent public accounting firm used in tax
consultation, continually evaluates complicated tax law requirements and their
effect on our current and future tax liability and our tax filing positions.
Despite our attempt to make an accurate estimate, the ultimate utilization of
our deferred tax assets associated with the tax basis of our leased gaming
equipment and property and equipment of $15.8 million is largely dependent
upon our ability to generate taxable income in the future. Our liability for
uncertain tax positions is dependent upon our judgment on the amount of
financial statement benefit that an uncertain tax position will realize upon
ultimate settlement and on the probabilities of the outcomes that could be
realized upon ultimate settlement of an uncertain tax position using the facts,
circumstances and information available at the reporting date to establish the
appropriate amount of financial statement benefit. To the extent that a
valuation allowance or uncertain tax position is established or increased or
decreased during a period, we may be required to include an expense or benefit
within income tax expense in the income statement.
  LIQUIDITY
AND CAPITAL RESOURCES
  At
December 31, 2008, we had $2.9 million in unrestricted cash
and cash equivalents, compared to $6.3 million at
September 30, 2008. Our working capital at December 31, 2008
was $19.7 million, compared to a working capital of $34.1 million at
September 30, 2008. The decrease in working capital was primarily the
result of decreases in accounts receivable and notes receivable, and increases
in accounts payable and accrued expenses. During the three-months ended
December 31, 2008, we used $25.1 million for capital expenditures
of property and equipment, and we collected $1.8 million on development
agreements. As of December 31, 2008, we have $48.1 million
available under the Credit Facility, subject to covenant
restrictions
  -30-




As of
December 31, 2008, our total contractual cash obligations were as
follows (in thousands):
  Less than
                      1 year
                    
                    
                    1-3 years
                    
                    
                    3-5 years
                    
                    
                    TotalRevolving
      Credit Facility(1)
                    
                    $
                    218
                    
                    
                    $
                    —
                    
                    
                    $
                    25,004
                    
                    
                    $
                    25,222Credit
      Facility Term Loan(2)
                    
                    
                    3,003
                    
                    
                    
                    1,500
                    
                    
                    
                    64,394
                    
                    
                    
                    68,897Operating
      leases(3)
                    
                    
                    2,590
                    
                    
                    
                    1,688
                    
                    
                    
                    
                    
                    
                    
                    4,278Purchase
      commitments(4)
                    
                    
                    3,375
                    
                    
                    
                    3,375
                    
                    
                    
                    —
                    
                    
                    
                    6,750Total
                    
                    $
                    9,186
                    
                    
                    $
                    6,563
                    
                    
                    $
                    89,398
                    
                    
                    $
                    105,147
  (1)
                  Relating
      to the Revolving Credit Facility, bearing interest at the Eurodollar rate
      plus the applicable spread (7.81% as of
      December 31, 2008).
 (2)
                  Consists
      of amounts borrowed under our Credit Facility at the Eurodollar rate plus
      the applicable spread (8.56% as of
      December 31, 2008).
 (3)
                  Consists
      of operating leases for our facilities and office equipment that expire at
      various times
through 2011.
 (4)
                  Consists
      of commitments to order third-party gaming content licenses and for the
      purchase of player
terminals.
  During
the three months ended December 31, 2008, we generated
$13.3 million in cash from our operations, compared to $11.0 million
during the same period of 2007. This $2.3 million increase in cash
generated from operations over the prior period was primarily due to the
increase in accounts payable which is offset by the increase in
inventory.
  Cash used
in investing activities decreased to $24.1 million in the three months
ended December 31, 2008, from $28.1 million in the same
period of 2007. The decrease was primarily the result of a decrease in
advances under development agreements offset by the purchase of capital
expenditures of property and equipment. During the three months ended
December 31, 2008, additions to property and equipment consisted of
the following:
  Capital Expenditures(In
      thousands)Gaming
      equipment
                    
                    $
                    20,940Third-party
      gaming content licenses
                    
                    
                    4,106Other
                    
                    
                    28Total
                    
                    $
                    25,074
  Cash
provided by financing activities decreased to $7.2 million in the three
months ended December 31, 2008, from a usage of $11.5 million in
the same period of 2007. The decrease was primarily the result of a
$4.2 million decrease in the net borrowings under the Credit
Facility
  Our
capital expenditures for the next 12 months will depend upon the number of
new player terminals that we are able to place into service at new or existing
facilities and the actual number of repairs and equipment upgrades to the player
terminals that are currently in the field. As a result of the earnings potential
of compact games in the Oklahoma market, it is our strategy to either place
compact games or to convert our Oklahoma Class II games to the compact
games. As part of our strategy, we will offer compact games developed by us, as
well as games from two other gaming suppliers. As a result, we have entered into
purchase commitments for future purchases of player stations and licenses
totaling $3.4 million.
  We have
recently fulfilled a commitment to a significant, existing tribal customer to
provide approximately 43.8%, or $65.6 million, of the total funding
for a facility expansion. Because of our commitment to fund the expansion, we
secured the right to place an additional 1,400 gaming units in the expanded
facility in southern Oklahoma. We recorded all advances as a note receivable and
imputed interest on the interest free loan. The discount (imputed interest) was
recorded as contract rights and will be amortized over the life of the
agreement. The repayment period of the note will be based on the performance of
the facility. As of December 31, 2008, the Company had installed the
additional 1,400 units.
  We are
currently in compliance with our Senior Secured Credit Agreement's covenants.
However, we believe there is substantial risk in our continued satisfaction of
certain operating covenants in that agreement following conclusion of this
fiscal quarter. In particular, our ability to remain in compliance with our
trailing twelve month EBITDA covenant is dependent upon our ability to achieve
our current operating plan for this quarter. In light of (i) current
prevailing economic conditions and the inherent uncertainty of achieving and
recognizing future revenue, and (ii) the difficulty of making short-term
expense reductions sufficient to compensate for a revenue shortfall, we cannot
be certain that we will be able to achieve our operating objectives this quarter
and thereby continue to meet the EBITDA covenant, among others.
  If we
fail to remain in compliance with our Senior Secured Credit Agreement covenants,
we will be required to seek modification or waiver of the provisions of that
agreement and potentially secure additional sources of capital. We have held
discussions with our lead agent, and are preparing to meet with them and other
members of our lending syndicate, to discuss alternatives and contingent plans
in the event that we fall out of compliance with the Credit Facility’s operating
covenants. We cannot be certain that, if required, we will be able to
successfully negotiate required changes to or waivers of our Senior Secured
Credit Facility. Alternatively, we may incur significant costs related to
obtaining requisite waivers or renegotiation of our Credit Facility that could
have a material and adverse effect on our operating results.
  Our
performance and financial results are, to a certain extent, subject to
(i) general conditions in or affecting the Native American gaming industry,
and (ii) general economic, political, financial, competitive and regulatory
factors beyond our control. If our business does not continue to generate cash
flow at appropriate levels or if we receive a material judgment against us in
one of the various lawsuits (See “Risk Factors – “The ultimate outcome of
pending litigation is uncertain,” and Commitments and Contingencies), we may
need to raise additional financing. Sources of additional financing might
include additional bank debt or the public or private sale of equity or debt
securities. However, sufficient funds may not be available, on terms acceptable
to us or at all, from these sources or any others to enable us to make necessary
capital expenditures and to make discretionary investments in the
future.
 -31-
  Credit
Facility
  On
April 27, 2007, we entered into a $150 million Revolving Credit
Facility which replaced our Previous Credit Facility in its entirety. On
October 26, 2007, we amended the Revolving Credit Facility,
transferring $75 million of the revolving credit commitment to a fully
funded $75 million term loan due April 27, 2012. The Term Loan is
amortized at an annual amount of 1% per year, payable in equal quarterly
installments beginning January 1, 2008, with the remaining amount due
on the maturity date. We entered into a second amendment to the Revolving Credit
Facility on December 20, 2007. The second amendment (i) extended
the hedging arrangement date related to a portion of the term loan to
June 1, 2008; and (ii) modified the interest rate margin
applicable to the Revolving Credit Facility and the term loan.
  The
Credit Facility provides us with the ability to finance development agreements
and acquisitions and working capital for general corporate purposes. Amounts
under the $75 million revolving credit commitment and the $75 million
term loan mature in five years, and advances under the term loan and revolving
credit commitment bear interest at the Eurodollar rate plus the applicable
spread (7.81% and 8.56%, respectively, as of
December 31, 2008), tied to various levels of interest pricing
determined by total debt to EBITDA.
  The
Credit Facility is collateralized by substantially all of our assets, and also
contains financial covenants as defined in the agreement. These covenants
include (i) a minimum fixed-charge coverage-ratio of not less
than 1.50 : 1.00; (ii) a maximum total debt to EBITDA ratio
of not more than 2.25 : 1.00 through June 30, 2008,
and 1.75 : 1.00 from September 30, 2008 thereafter; and
(iii) a minimum trailing twelve-month EBITDA of not less than
$57 million for the quarter ended September 30, 2007, and
$60 million for each quarter thereafter.  The trailing
twelve-month EBIDTA, as computed under the Credit Facility, was
$60.2 million as of December 31, 2008. As of
December 31, 2008, we are in compliance with the loan covenants.
However, we will need to generate a minimum of $16.8 million in EBITDA in
the March 2009 fiscal quarter if we are to remain in compliance with the
EBITDA covenant (assuming no prior waiver or modification of such
covenant).
  If the
Company is able to achieve its operating objectives in the March 2009
quarter, we believe the Company will remain in compliance with the financial
covenants. Our operating objectives for the quarter include maintaining current
levels of recurring revenue as well as the successful sale of Class III
gaming equipment and recognition of related revenue from such sales. Given
current economic conditions and the inherent uncertainty surrounding the timing
of Class III gaming equipment and related revenue recognition, we believe
there is significant risk that we will not meet our operating objectives for the
quarter. If the Company’s performance does not meet current objectives, we may
not meet the EBITDA covenant, among others (See Risk Factors – “Our Credit
Facility contains covenants that limit our ability to finance future operations
or capital needs, or to engage in other business activities”).
  The
Credit Facility requires certain mandatory prepayments be made on the term loan
from the net cash proceeds of certain asset sales and condemnation proceedings
(in each case to the extent not reinvested, within certain specified time
periods, in the replacement or acquisition of property to be used in our
businesses). In the second quarter of 2008, we made a mandatory prepayment
of the term loan in the amount of $4.5 million due to an early prepayment
of a development agreement note receivable. As of December 31, 2008,
the Credit Facility had availability of $48.1 million, subject to covenant
restrictions.
 The
Credit Facility also required that we enter into hedging arrangements covering
at least $50 million of the term loan for a three-year period by
June 1, 2008. Therefore, on May 29, 2008, we purchased, for
$390,000, an interest rate cap (5% cap rate) covering $50 million of
the term loan. We account for this hedge in accordance with Statement of
Financial Accounting Standards No. 133, or SFAS No. 133, “Accounting
for Derivative Instruments and Hedging Activities,” which requires entities to
recognize all derivative instruments as either assets or liabilities in the
balance sheet, at their respective fair values. We record changes on a mark to
market basis reflecting these changes through interest expense in the statement
of operations. The fair value of this hedge was approximately $20,000 at
December 31, 2008.
  Stock-Based
Compensation
  At
December 31, 2008, we had approximately 6.8 million options
outstanding, with exercise prices ranging from $1.00 to $18.71 per
share. At December 31, 2008, approximately 3.8 million of the
outstanding options were exercisable.
  During
the three months ended December 31, 2008, options to purchase
277,000  shares of common stock were granted and we issued 33,821
shares of common stock as a result of stock option exercises with an average
exercise price of $1.21.
  SEASONALITY
  We
believe our operations are not materially affected by seasonal factors, although
we have experienced fluctuations in our revenues from period to
period.
  -32-
  CONTINGENCIES
  For
information regarding contingencies, see “Item 1. Condensed Financial
Statements – Note 8 - Commitments and Contingencies” and “PART II –
Item 1. Legal Proceedings.”
  INFLATION
AND OTHER COST FACTORS
  Our
operations have not been nor are they expected to be materially affected by
inflation. However, our domestic and international operational expansion is
affected by the cost of hardware components, which are not considered to be
inflation sensitive, but rather, sensitive to changes in technology and
competition in the hardware markets. In addition, we expect to continue to incur
increased legal and other similar costs associated with regulatory compliance
requirements and the uncertainties present in the operating environment in which
we conduct our business.
  ITEM
      3.
              QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
  We are
subject to market risks in the ordinary course of business, primarily associated
with interest rate fluctuations.
  Our
Credit Facility provides us with additional liquidity to meet our short-term
financing needs, as further described under “Item 1. Condensed Financial
Statements - Note 6 – Credit Facility, Long-Term Debt and Capital Leases.”
Pursuant to our Revolving Credit Facility, we may currently borrow up to a total
of $143.0 million, and our availability as of December 31, 2008,
is $48.1 million, subject to covenant restrictions.
  In
connection with the development agreements we enter into with many of our Native
American tribal customers, we are required to advance funds to the tribes for
the construction and development of tribal gaming facilities, some of which are
required to be repaid. As a result of our adjustable-interest-rate notes payable
and fixed-interest-rate-notes receivable described in “Item 1. Condensed
Financial Statements – Note 5 – Notes Receivable and Note 6 – Credit
Facility, Long-Term Debt and Capital Leases,” we are subject to market risk with
respect to interest rate fluctuations. Any material increase in prevailing
interest rates could cause us to incur significantly higher interest
expense.
  The
Credit Facility also required that we enter into hedging arrangements covering
at least $50 million of the term loan for a three-year period. On
May 29, 2008, we purchased, for $390,000, an interest rate cap
(5% cap rate) covering $50 million of the term loan. To the extent
that Libor rates do not exceed the 5% cap rate, we estimate that a
hypothetical increase of 100 basis points in interest rates would increase
our annual interest expense by approximately $950,000, based on our
variable debt outstanding of $94.1 million as of
December 31, 2008.
  We
account for currency translation from our Mexico operations in accordance with
SFAS No. 52, “Foreign Currency Translation.” Balance sheet accounts
are translated at the exchange rate in effect at each balance sheet date. Income
statement accounts are translated at the average rate of exchange prevailing
during the period. Translation adjustments resulting from this process are
charged or credited to other comprehensive income. We do not currently manage
this exposure with derivative financial instruments.
  ITEM
      4.
              CONTROLS
      AND PROCEDURES
  Evaluation of
Disclosure Control and Procedures.As of the end of the
period covered by this report, an evaluation was carried out under the
supervision and with the participation of our management, including our Chief
Executive Officer and our Chief Financial Officer, of the effectiveness of the
design and operation of management’s disclosure controls and procedures (as
defined in rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934) to ensure information required to be disclosed in our filings under the
Securities Exchange Act of 1934, is (i) recorded, processed, summarized and
reported within the time periods specified in the SEC rules and forms; and
(ii) accumulated and communicated to our management, including our Chief
Executive Officer and our Chief Financial Officer, as appropriate, to allow
timely decisions regarding required disclosure. Management recognizes that any
controls and procedures, no matter how well designed and operated, can only
provide reasonable assurance of achieving desired control objectives, and
management is necessarily required to apply its judgment when evaluating the
cost-benefit relationship of potential controls and procedures. Based upon the
evaluation, the Chief Executive Officer and our Chief Financial Officer
concluded that the design and operation of these disclosure controls and
procedures were effective as of December 31, 2008.
  -33-
  There
were no significant changes in our internal controls or in other factors that
could significantly affect these controls subsequent to the date of their
evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.
  Changes in
Internal Control over Financial Reporting.There
were no changes in our internal control over financial reporting identified in
management’s evaluation during the first quarter of fiscal 2009 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
  -34-
  PART
II
 OTHER
INFORMATION
  ITEM
      1.
              LEGAL
      PROCEEDINGS
  We are
subject to litigation from time to time in the ordinary course of our business,
as well as litigation to which we are not a party that may establish laws that
affect our business (see “PART I – Item 1. Condensed Financial
Statements – Note 8 – Commitments and Contingencies.”)
  ITEM
      1A.
              RISK
      FACTORS
  The
following risk factors should be carefully considered in connection with the
other information and financial statements contained in this Quarterly Report,
including “PART I – Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations.” If any of these risks actually
occur, our business, financial condition and results of operations could be
seriously and materially harmed, and the trading price of our common stock could
decline.
  Our
business operations and product offerings are subject to strict regulatory
licenses, findings of suitability, registrations, permits and/or
approvals.
  Our
ability to conduct our existing traditional business, expand operations, develop
and distribute new products, games and systems, and expand into new gaming
markets is subject to significant federal, state, local, Native American, and
foreign regulations. Specifically, our company and its officers, directors, key
employees, major shareholders, and products, games and systems are subject to
licenses, findings of suitability, registrations, permits or approvals necessary
for the operation of our gaming activities.
  We have
received licenses, findings of suitability, registrations, permits or approvals
from a number of state, local, Native American, and foreign gaming regulatory
authorities. Our tribal customers are empowered to develop their own licensing
procedures and requirements, and we currently have limited, if any, information
regarding the ultimate process or expenses involved with securing or maintaining
licensure by the tribes. Moreover, tribal policies and procedures, as well as
tribal selection of gaming vendors, are subject to the political and governance
environment within the tribe.
  We may
require new licenses, permits and approvals in the future, and such licenses,
permits or approvals may not be granted to us. Obtaining and maintaining all
required licenses, findings of suitability, registrations, permits or approvals
is time consuming and expensive. The suspension, revocation, nonrenewal or
limitation of any of our licenses would have a material adverse effect on our
business operations, financial condition and results of operations.
  Our
ability to effectively compete in Native American gaming markets is vulnerable
to legal and regulatory uncertainties.
  Historically,
we have derived most of our revenue from the placement of Class II player
terminals and systems for gaming activities conducted on Native American lands.
These activities are subject to federal regulation under the Gambling Devices
Act, 15 U.S.C. § 1171, et seq
(“Johnson Act”), the Indian Gaming Regulatory Act of 1988 (“IGRA”), the
National Indian Gaming Commission (“NIGC”), and the regulatory requirements of
various tribal gaming commissions. The Johnson Act broadly defines “gambling
devices” to include any “machine or mechanical device” designed and manufactured
“primarily” for use in connection with gambling, and that, when operated,
delivers money or other property to a player “as the result of the application
of an element of chance.” A government agency or court that literally applied
this definition, and did not give effect to subsequent congressional legislation
or to certain regulatory interpretations or judicial decisions, could determine
that the manufacture and use of our electronic player terminals, and perhaps
other key components of our Class II gaming systems that rely to some
extent upon electronic equipment to run a game, constitute Class III gaming
and, in the absence of a tribal-state compact, are illegal. Our tribal customers
could be subject to significant fines and penalties if it is ultimately
determined they are offering an illegal game, and an adverse regulatory or
judicial determination regarding the legal status of our products could have
material adverse consequences for our business, operating results and prospects.
Other government enforcement, regulatory action, judicial decisions, proposed
legislative action, rumors that have in the past and will continue to affect our
business, operating results and prospects, include but are not limited
to:
  §
              proposed
      legislation that would classify electronic technologic aids used by Native
      American tribes in Class II games, such as bingo, as gambling
      devices, or require certification by the NIGC of the Class II technologic
      aids;
  -35-
  §
              proposed
      legislation that would authorize the NIGC to promulgate regulations
      regarding the use of technologic
aids;
  §
              proposed
      rules by the NIGC concerning classification standards to distinguish
      between Class II games played with technologic aids and
      Class III facsimiles of games of chance, a revision of the definition
      of “electronic or electromechanical
facsimile”;
  §
              proposed
      legislation or rules that would allow the NIGC authority to review
      contracts between Native American tribes and their
    suppliers;
  §
              government
      enforcement, regulatory action, judicial decisions, or the prospects of
      rumors involving any of our games which have not been reviewed or approved
      as legal Class II games by the NIGC (inclusive but not limited to our
      games placed in both Charitable Bingo and International Bingo
      markets);
  §
              contractual
      and regulatory interpretations and enforcement actions by state regulators
      or courts with regard to compacts between the state and various tribes,
      including but not limited to tribes with compacts in the states of
      Washington and Oklahoma;
  §
              adverse
      rulings regarding game classification by state or federal
      courts;
  §
              adverse
      regulatory decisions by tribal gaming
  commissions;
  §
              lack
      of regulatory or judicial enforcement action. In particular, we believe we
      have lost, and could continue to lose, market share to competitors who
      offer games that do not appear to comply with published regulatory
      restrictions on Class II games, and thereby offer features not
      available in our products;
  §
              the
      use of sovereign immunity by the tribes to interfere with our ability to
      enforce our contractual rights on Native American
  land;
  §
              new
      laws and regulations relating to Native American gaming that may be
      enacted, and existing laws and regulations that could be amended or
      reinterpreted in a manner adverse to our
  business;
  §
              investigations
      by the Inspector General for the Department of the Interior and the Acting
      General Counsel for the NIGC into the practice of certain tribes
      conducting gaming on land originally acquired in trust for non-gaming
      purposes; and
  §
              a
      determination by the NIGC that our development agreements, either by
      themselves or when taken together with other agreements demonstrate a
      proprietary interest by us in a tribe’s gaming activity. Management
      contracts are subject to additional regulatory requirements and oversight,
      including preapproval by the NIGC, that could delay our providing products
      and services to customers, as well as divert customers to our
      competitors.
  All of
the above risk factors could result in significant and immediate adverse impacts
on our business and operating results. Additionally, each of the above described
risk factors increases the cost of doing business and could take our executives’
attention away from operations. The trading price of our common stock has in the
past and may in the future be subject to significant fluctuations based upon
market perceptions of the legal status of our products and our ability to
compete in the Native American markets. Regulatory action against our customers
or equipment in these or in other markets could result in machine seizures and
significant revenue disruptions, among other adverse consequences. Moreover,
tribal policies and procedures, as well as tribal selection of gaming vendors,
are subject to the political and governance environment within the tribe.
Changes in tribal leadership or tribal political pressure can affect our
business relationships within Native American markets.
  The
ultimate outcome of pending litigation is uncertain.
  We are
involved in a number of commercial and intellectual property litigation matters.
Current estimates of loss regarding pending litigation may not be reflective of
any particular final outcome. The results of rulings, judgments or settlements
of pending litigation may result in financial liability that is materially
higher than what management has estimated at this time. We make no assurances
that we will not be subject to liability with respect to current or future
litigation. We maintain various forms of insurance coverage. However,
substantial rulings, judgments or settlements could exceed the amount of
insurance coverage (or any cost allocation agreement with an insurance carrier),
or could be excluded under the terms of an existing insurance policy.
Additionally, failure to secure favorable outcomes in pending litigation could
result in adverse consequences to our business, operating results and/or overall
financial condition (including without limitation, possible adverse effects on
compliance with the terms of our Credit Facility).
  -36-
  We
may have difficulty enforcing contractual rights on Native American
land.
  Federally
recognized Native American tribes are independent governments, subordinate to
the United States, with sovereign powers, except as those powers may have been
limited by treaty or by the United States Congress. The power of Native
Americans tribes to enact their own laws and to regulate gaming operations and
contracts is an exercise of Native American sovereignty, as recognized by IGRA.
Native American tribes maintain their own governmental systems and often their
own judicial systems. Native American tribes have the right to tax persons and
enterprises conducting business on Native American lands, and also have the
right to require licenses and to impose other forms of regulation and regulatory
fees on persons and businesses operating on their lands.
  In the
absence of a specific grant of authority by Congress, states may regulate
activities taking place on Native American lands only if the tribe has a
specific agreement or compact with the state. Our contracts with Native American
customers normally provide that only certain provisions will be subject to the
governing law of the state in which a tribe is located. However, these
choice-of-law clauses may not be enforceable.
  Native
American tribes generally enjoy sovereign immunity from lawsuits similar to that
of the individual states and the United States. In order to sue a Native
American tribe (or an agency or instrumentality of a Native American tribe), the
tribe must have effectively waived its sovereign immunity with respect to the
matter in dispute.
  Our
contracts with some Native American customers include a limited waiver of each
tribe’s sovereign immunity, and generally provide that any dispute regarding
interpretation, performance or enforcement shall be submitted to, and resolved
by, arbitration in accordance with the Commercial Arbitration Rules of the
American Arbitration Association, and that any award, determination, order or
relief resulting from such arbitration is binding and may be entered in any
court having jurisdiction. However, in some instances, there is no limited
waiver of sovereign immunity. Our largest customer, who accounts for
over 46% of our revenue, has not given us a limited waiver of sovereign
immunity. In the instances where tribes have not waived sovereign immunity, or
in the event that a limited waiver of sovereign immunity is held to be
ineffective, we could be precluded from judicially enforcing any rights or
remedies against a tribe. These rights and remedies include, but are not limited
to, our right to enter Native American lands to retrieve our property in the
event of a breach of contract by the tribe party to that contract.
  If a
Native American tribe has effectively waived its sovereign immunity, there
exists an issue as to the forum in which a lawsuit can be brought against the
tribe. Federal courts are courts of limited jurisdiction and generally do not
have jurisdiction to hear civil cases relating to Native Americans. In addition,
contractual provisions that purport to grant jurisdiction to a federal court are
not effective. Federal courts may have jurisdiction if a federal question is
raised by the lawsuit, which is unlikely in a typical contract dispute.
Diversity of citizenship, another common basis for federal court jurisdiction,
is not generally present in a lawsuit against a tribe, because a Native American
tribe is not considered a citizen of any state. Accordingly, in most commercial
disputes with tribes, the jurisdiction of the federal courts may be difficult or
impossible to obtain. We may be unable to enforce any arbitration decision
effectively.
  Our
expansion into non-Native American gaming activities will present new challenges
and risks that could adversely affect our business or results of
operations.
  As we
expand into new markets, we expect to encounter business, legal, operational and
regulatory uncertainties similar to those we face in our Native American gaming
business. As a result, we may encounter legal and regulatory challenges that are
difficult or impossible to foresee and which could result in an unforeseen
adverse impact on planned revenues or costs associated with the new market
opportunity. If we are unable to effectively develop and operate within these
new markets, then our business, operating results and financial condition would
be impaired.
  Successful
growth in accordance with our strategy may require us to make changes to our
gaming systems to ensure that they comply with applicable regulatory
requirements, and may require us to obtain additional licenses. In certain
jurisdictions and for certain venues, our ability to enter these markets will
depend on effecting changes to existing laws and regulatory regimes. The ability
to effect these changes is subject to a great degree of uncertainty and may
never be achieved. We may not be successful in entering into other segments of
the gaming industry.
  -37-
  Generally,
our placement of systems, games and technology into new market segments involves
a number of business uncertainties, including:
  §
              whether
      our resources and expertise will enable us to effectively operate and grow
      in such new markets;
  §
              whether
      our internal processes and controls will continue to function effectively
      within these new segments;
  §
              whether
      we have enough experience to accurately predict revenues and expenses in
      these new markets;
  §
              whether
      the diversion of management attention and resources from our traditional
      business, caused by entering into new market segments, will have harmful
      effects on our traditional
business;
  §
              whether
      we will be able to successfully compete against larger companies who
      dominate the markets that we are trying to enter;
  and
  §
              whether
      we can timely perform under our agreements in these new
      markets.
  Our
Credit Facility contains covenants that limit our ability to finance future
operations or capital needs, or to engage in other business
activities.
  The
operating and financial restrictions and covenants in our debt agreements,
including the Credit Facility, may adversely affect our ability to finance
future operations or capital needs or to engage in other business activities.
Our Credit Facility requires us to maintain a minimum EBITDA of $60 million
on a trailing 12 month basis, a total debt to EBITDA leverage ratio of no
more than 1.75:1.00 and a minimum fixed charge coverage ratio of at
least 1.5:1.0. The Credit Facility contains certain covenants that, among
other things, restrict our ability as well as our restricted subsidiaries’
ability to:
  §
              incur
      additional indebtedness, assume a guarantee or issue preferred
      stock;
  §
              pay
      dividends or make other equity distributions or payments to or affecting
      our subsidiaries;
  §
              purchase
      treasury stock;
  §
              make
      certain investments;
  §
              create
      liens;
  §
              sell
      or dispose of assets or engage in mergers or
    consolidations;
  §
              engage
      in certain transactions with subsidiaries and affiliates;
    and
  §
              enter
      into sale leaseback transactions.
  These
restrictions could limit our ability to obtain future financing, make strategic
acquisitions or needed capital expenditures, withstand economic downturns in our
business or the economy in general, conduct operations or otherwise take
advantage of business opportunities that may arise. A failure to comply with the
restrictions contained in the Credit Facility could lead to an event of default,
which could result in an acceleration of our indebtedness. Such acceleration
would constitute an event of default under the indentures governing the senior
unsecured notes. Our future operating results may not be sufficient to enable
compliance with the covenants in the Credit Facility or to remedy any such
default. In addition, in the event of acceleration, we may not have or be able
to obtain sufficient funds to refinance our indebtedness or make any accelerated
payments. Also, we may not be able to obtain new financing. Even if we were able
to obtain new financing, we cannot guarantee that the new financing will be on
commercially reasonable terms or terms that are acceptable to us. If we default
on our indebtedness, our business financial condition and results of operation
could be materially and adversely affected.
  -38-
  Our
expansion into international gaming markets will present new challenges and
risks that could adversely affect our business or results of
operations.
  We have
only recently begun to develop international business, and we realized revenue
from the sale of an Electronic Instant Lottery System to the Israel National
Lottery during fiscal 2006 and from contracts to supply Electronic Bingo
Terminals to casinos in Mexico during fiscal years 2006, 2007, and 2008.
Neither our transactions in Israel nor in Mexico have been profitable to date or
are currently profitable, and may not lead to future profitable business. To
date, we do not have as many permanent facilities opened in Mexico as we
originally projected, and the hold per day in certain of the open facilities in
Mexico has not met our original expectations. There can be no assurances that
our games will gain market acceptance in Mexico, additional facilities will open
in Mexico, or that the hold per day will increase in those facilities in Mexico
currently not meeting our expectations. International transactions are subject
to various risks, including but not limited to:
  §
              currency
      fluctuations;
  §
              higher
      operating costs due to local laws or
  regulations;
  §
              unexpected
      changes in regulatory requirements;
  §
              tariffs
      and other trade barriers;
  §
              costs
      and risks of localizing products for foreign
  countries;
  §
              difficulties
      in staffing and managing geographically disparate
    operations;
  §
              greater
      difficulty in safeguarding intellectual property, licensing and other
      trade restrictions;
  §
              challenges
      negotiating and enforcing contractual
  provisions;
  §
              repatriation
      of earnings; and
  §
              anti-American
      sentiment due to the war in Iraq and other American policies that may be
      unpopular in certain regions, particularly in the Middle
    East.
  Interpretations
of federal regulations by governmental agencies may affect our
business.
  We may
face regulatory risks as a result of interpretations of other federal
regulations, such as banking regulations, as applied to our gaming systems. We
may be required to make changes to our games to comply with such regulations,
with attendant costs and delays that could adversely affect our business.
Specifically, the IRS is conducting a Bank Secrecy Act audit at one of the
tribal casinos, and the NIGC has deferred a determination of whether the tribal
gaming operations are in compliance with 25 C.F.R. § 542.3(c)(2)
until the IRS audit is completed.
  We
may be unable to develop, enhance or introduce successful gaming systems and
games.
  We may be
unable to successfully and cost effectively develop and introduce new and
enhanced gaming systems, games and content that will be widely accepted both by
our customers and their end users. Additionally, we may be unable to enhance
existing products in a timely manner in response to changing regulatory, legal
or market conditions or customer requirements, or new products or new versions
of our existing products may not achieve market acceptance. A decrease in demand
for our games could also result in an increase in our inventory obsolescence
charges.
  We
have limited control over our customers’ casino operations.
  Collectively
our senior management has decades of successful experience in gaming operations.
Where appropriate, we seek to provide assistance to our key customers in the
form of project management, with a focus on facility layout and planning, gaming
floor configuration and customized marketing and promotional initiatives.
However, our key customers are solely responsible for the operations of their
facilities. Our key customers may not take our advice on their operations,
marketing, facility layout, gaming floor configuration, or promotional
initiatives.To the extent
that our machines are not a part of an optimized facility layout or gaming floor
configuration, or to the extent that our machines are not supported by effective
marketing or promotional initiatives, our operating results could
suffer.
  -39-
  We
are dependent upon a few customers who are based in Oklahoma.
  For the
three months ended December 31, 2008 and 2007,
approximately 68% and 57%, respectively, of our gaming revenues were
from Native American tribes located in Oklahoma, and approximately 46%
and 40%, respectively, of our gaming revenues were from one tribe in that
state. The significant concentration of our customers in Oklahoma means that
local economic changes may adversely affect our customers, and therefore our
business, disproportionately to changes in national economic conditions,
including more sudden adverse economic declines or slower economic recovery from
prior declines. The loss of any of our Oklahoma tribes as customers would have a
material and adverse effect upon our financial condition and results of
operations. In addition, the legislation allowing tribal-state compacts in
Oklahoma has resulted in increased competition from other vendors, who we
believe have avoided entry into the Oklahoma market due to its uncertain and
ambiguous legal environment. The legislation allows for other types of gaming,
both at tribal gaming facilities and at Oklahoma racetracks. The loss of
significant market share to these new gaming opportunities or the increased
presence of our competitors’ products in Oklahoma could also have a material
adverse effect upon our financial condition and results of
operations.
  We
believe the introduction of more aggressive instant bingo machines, with
characteristics of traditional slot machines, into the Oklahoma market, has
adversely affected our operating results and market position in that state and
may continue to do so in the future.
  State
compacts with our existing Native American customers to allow Class III
gaming could reduce demand for our Class II games.
  As our
Class II tribal customers enter into compacts with the states in which they
operate, allowing the tribes to offer Class III games, we believe the
number of our game machine placements in those customers’ facilities could
decline significantly, and our operating results could be materially and
adversely affected. As our tribal customers make the transition to gaming under
compacts with the state, we believe there will be significant uncertainty in the
market for our games that will make our business more difficult to manage or
predict.
  As a
result, we anticipate further pressure on our market and revenue share
percentages in Oklahoma or the market could shift from revenue share
arrangements to a “for sale” model. We believe the establishment of state
compacts depends on a number of political, social, and economic factors that are
inherently difficult to ascertain. Accordingly, although we attempt to closely
monitor state legislative developments that could affect our business, we may
not be able to timely predict when or if a compact could be entered into by one
or more of our tribal customers.
  We
may not realize satisfactory returns on money lent to new and existing customers
to develop or expand gaming facilities.
  We enter
into development agreements to provide financing for construction or remodeling
of gaming facilities, primarily in the state of Oklahoma. Under our development
agreements, we secure a long-term revenue share percentage and a fixed number of
player terminal placements in the facility, in exchange for development and
construction funding. However, we may not realize the anticipated benefits of
any of these strategic relationships or financing. In connection with one or
more of these transactions, and to obtain the necessary development funds, we
may issue additional equity securities which would dilute existing stockholders;
extend secured and unsecured credit to potential or existing tribal customers
that may not be repaid; incur debt on terms unfavorable to us or that we are
unable to repay; and incur contingent liabilities.
  Our
development efforts or financing activities may result in unforeseen operating
difficulties, financial risks, or required expenditures that could adversely
affect our liquidity. It may also divert the time and attention of our
management that would otherwise be available for ongoing development of our
business. In addition, certain of the agreements contain performance standards
for our player terminals that could allow the facility to reduce a portion of
our player terminals.
  The NIGC
has expressed its view that our development agreements violate the requirements
of IGRA and tribal gaming regulations, which state that the Native American
tribes must hold “sole proprietary interest” in the tribes’ gaming operations,
which presents additional risks for our business (See “Risk Factors – Our
ability to effectively compete in Native American gaming markets is vulnerable
to legal and regulatory uncertainties.”)
  In the
past we have, and in the future we expect to, reduce our floor space in certain
of our Class II facilities as a result of ongoing competitive pressures
faced by our customers from alternative gaming facilities and faced by our
machines from competitors’ products. In addition, future NIGC decisions could
affect our ability to place our games with these tribes.
  -40-
  Our
industry is intensely competitive.
  We
operate in an intensely competitive industry against larger companies with
significant financial, research design and development, and marketing resources.
These larger companies are aggressively competing against us in our core
business operations, including but not limited to, charity bingo, lottery, Class
II, Class III, and international bingo markets. Additionally, new smaller
competitors may enter our traditional markets. The increased competition will
intensify pressure on our pricing model. We expect to face increased competition
as we attempt to enter new markets and new geographical locations. In the
future, gaming providers will compete on the basis of price as well as the
entertainment value and technological superiority of their
products.
  Other
members of our industry may independently develop games similar to our games,
and competitors may introduce noncompliant games that unfairly compete in
certain markets due to uneven regulatory enforcement policies.
  Additionally,
our customers compete with other providers of entertainment for their end user’s
entertainment budget. Consequently, our customers might not be able to spend new
capital on acquiring gaming equipment. Moreover, our customers might reduce
their utilization of revenue share agreements.
  We
may not be able to successfully implement new sales strategies.
  As we
attempt to generate new streams of revenue by selling Class III units to new
customers we may have difficulty implementing an effective sales strategy. Our
failure to successfully implement an effective sales strategy could result in
our future operating results to vary materially from what management has
forecast.
  We
may not be successful in protecting our intellectual property rights, or
avoiding claims that we are infringing upon the intellectual property rights of
others.
  We rely
upon patent, copyright, trademark and trade secret laws, license agreements and
employee nondisclosure agreements to protect our proprietary rights and
technology, but these laws and contractual provisions provide only limited
protection. We rely to a greater extent upon proprietary know-how and continuing
technological innovation to maintain our competitive position. Insofar as we
rely on trade secrets, unpatented know-how and innovation, others may be able to
independently develop similar technology, or our secrecy could be breached. The
issuance of a patent to us does not necessarily mean that our technology does
not infringe upon the intellectual property rights of others. As we enter into
new markets by leveraging our existing technology, and by developing new
technology and new products, it becomes more and more likely that we will become
subject to infringement claims from other parties. We are currently involved in
several patent disputes. See ”Part I – Item I. Condensed Financial Statements –
Note 8 – Commitments and Contingencies.” Problems with patents or other
rights could increase the cost of our products, or delay or preclude new product
development and commercialization. If infringement claims against us are valid,
we may seek licenses that might not be available to us on acceptable terms or at
all. Litigation would be costly and time consuming, but may become necessary to
protect our proprietary rights or to defend against infringement claims. We
could incur substantial costs and diversion of management resources in the
defense of any claims relating to the proprietary rights of others or in
asserting claims against others. We cannot guarantee that our intellectual
property will provide us with a competitive advantage or that it will not be
circumvented by our competitors.
  We
rely on software licensed from third parties, and on technology provided by
third-party vendors, the loss of which could increase our costs and delay
deployment or suspend development of our gaming systems and player
terminals.
  We
integrate various third-party software products as components of our software.
Our business would be disrupted if this software, or functional equivalents of
this software, were either no longer available to us or no longer offered to us
on commercially reasonable terms. In either case, we would be required to either
redesign our software to function with alternate third-party software, or to
develop these components ourselves, which would result in increased costs and
could result in delays in our deployment of our gaming systems and player
terminals. Furthermore, we might be forced to limit the features available in
our current or future software offerings.
  Our
Manufacturing and License Agreement with WMS Gaming, Inc., which was originally
entered into on May 17, 2004 and amended and restated on
June 29, 2005 (the “Agreement”), will expire under operation of its
terms on June 30, 2009. The Agreement enabled us to distribute, at a
discount, WMS licensed products (i) on an exclusive (except as to WMS)
basis in the Class II and Class III Native American market in
Oklahoma; (ii) on a limited exclusive basis (except as to WMS and subject
to WMS’ existing commitments) in the Class II Native American market in
North America, the pull tab and Class II-style bingo market in Mexico, and
in the Charity markets in Alabama; and (iii) on a non exclusive basis for
the Class III market in Washington. Although we may exercise certain
sell-off rights in Oklahoma and Mexico, after June 30, 2009, we
may continue to distribute WMS products, but without the benefits of a
contractual discount or a grant of exclusivity.
 We rely
on the content of certain software that we license from third-party vendors. The
software could contain bugs that could have an impact on our
business.
  We also
rely on the technology of third-party vendors, such as telecommunication
providers, to operate our nationwide broadband telecommunications network. A
serious or sustained disruption of the provision of these services could result
in some of our player terminals being non-operational for the duration of the
disruption, which would reduce over-all revenue from those player
terminals.
  -41-
  We
do not rely upon the term of our customer contracts to retain the business of
our customers.
  Our
contracts with our customers are on a year-to-year or multi-year basis. Except
for customers with whom we have entered into development agreements, we do not
rely upon the stated term of our customer contracts to retain the business of
our customers, as often noncontractual considerations unique to doing business
in the Native American market override strict adherence to contractual
provisions. We rely instead upon providing competitively superior player
terminals, games and systems to give our customers the incentive to continue
doing business with us. At any point in time, a significant portion of our
business is subject to nonrenewal, which may materially and adversely affect our
earnings, financial condition and cash flows.
  If
our key personnel leave us, our business could be materially adversely
affected.
  We depend
on the continued performance of the members of our senior management team and
our technology team. If we were to lose the services of any of our senior
officers, directors, or any key member of our technology team, and could not
find suitable replacements for such persons in a timely manner, it could have a
material adverse effect on our business.
  We
may incur prize payouts in excess of game revenues.
  Certain
of our contracts with our Native American customers relating to our Legacy and
Reel Time Bingo system games provide that our customers receive, on a daily
basis, an agreed percentage of gross gaming revenues based upon an assumed level
of prize payouts, rather than the actual level of prize payouts. This
arrangement can result in our paying our customers amounts greater than our
customers’ percentage share of the actual hold per day. In addition, because the
prizes awarded in our games are based upon assumptions as to the number of
players in each game and statistical assumptions as to the frequency of winners,
we may experience on any day, or over short periods of time, a “game deficit,”
where the aggregate amount of prizes paid exceeds aggregate game revenues. If we
have to make any excess payments to customers, or experience a game deficit over
any statistically relevant period of time, we are contractually entitled to
adjust the rates of prize payout to end users in order to recover any deficit.
In the future, we may miscalculate our statistical assumptions, or for other
reasons we may experience abnormally high rates of jackpot prize wins, which
could materially and adversely affect our cash flow on a temporary or long-term
basis, and which could materially and adversely affect our earnings and
financial condition.
  If
we fail to maintain an effective system of internal controls, we may not be able
to accurately report financial results or prevent fraud.
  Effective
internal controls are necessary to provide reliable financial reports and to
assist in the effective prevention of fraud. Any inability to provide reliable
financial reports or prevent fraud could harm our business. We must annually
evaluate our internal procedures to satisfy the requirements of Section 404
of the Sarbanes-Oxley Act of 2002, which requires management and auditors
to assess the effectiveness of internal controls. If we fail to remedy or
maintain the adequacy of our internal controls, as such standards are modified,
supplemented or amended from time to time, we could be subject to regulatory
scrutiny, civil or criminal penalties or shareholder litigation.
  In
addition, failure to maintain adequate internal controls could result in
financial statements that do not accurately reflect our financial condition.
There can be no assurance that we will be able to complete the work necessary to
fully comply with the requirements of the Sarbanes-Oxley Act or that our
management and our independent registered public accounting firm will continue
to conclude that our internal controls are effective.
  Our
business prospects and future success rely heavily upon the integrity of our
employees and executives and the security of our gaming systems.
  The
integrity and security of our gaming systems are critical to our ability to
attract customers and players. We strive to set exacting standards of personal
integrity for our employees and for system security involving the gaming systems
that we provide to our customers. Our reputation in this regard is an important
factor in our business dealings with our current and potential customers. For
this reason, an allegation or a finding of improper conduct on our part or on
the part of one or more of our employees that is attributable to us, or of an
actual or alleged system security defect or failure attributable to us could
have a material adverse effect upon our business, financial condition, results
and prospects, including our ability to retain existing contracts or obtain new
or renewed contracts.
  -42-
  Our
games and systems may experience loss based on malfunctions, anomalies or
fraudulent activities.
  Our games
and systems could produce false payouts as the result of malfunctions, anomalies
or fraudulent activities. We depend on our security precautions to prevent
fraud. We depend on regulatory safeguards, which may not be available in all
jurisdictions or markets, to protect us against jackpots awarded as a result of
malfunctions, anomalies or fraudulent activities. There can be no guarantee that
regulatory safeguards, in jurisdictions or markets were they do exist, will be
sufficient to protect us from liabilities associated with malfunctions,
anomalies or fraudulent activities.
  The
occurrence of malfunctions, anomalies or fraudulent activities could result in
litigation against us by our customers based on lost revenue or other claims
based in tort or breach of contract. Moreover, these occurrences could result in
investigations or disciplinary actions by applicable gaming
regulators.
  Any
disruption in our network or telecommunications services, or adverse weather
conditions in the areas in which we operate could affect our ability to operate
our games, which would result in reduced revenues and customer down
time.
  Our
network is susceptible to outages due to fire, floods, power loss, break-ins,
cyberattacks and similar events. We have multiple site back-up for our services
in the event of any such occurrence. Despite our implementation of network
security measures, our servers are vulnerable to computer viruses and break-ins.
Similar disruptions from unauthorized tampering with our computer systems in any
such event could have a material adverse effect on our business, operating
results and financial condition.
  Adverse
weather conditions, particularly flooding, tornadoes, heavy snowfall and other
extreme weather conditions often deter our end users from traveling, or make it
difficult for them to frequent the sites where our games are installed. If any
of those sites experienced prolonged adverse weather conditions, or if the sites
in Oklahoma, where a significant number of our games are installed,
simultaneously experienced adverse weather conditions, our results of operations
and financial condition would be materially and adversely affected.
  In
addition, our agreement with the New York State Division of the Lottery permits
termination of the contract at any time for failure by us or our system to
perform properly. Failure to perform under this contract or similar contracts
could result in substantial monetary damages, as well as contract
termination.
  In
addition, we enter into certain agreements that could require us to pay damages
resulting from loss of revenues if our systems are not properly functioning, or
as a result of a system malfunction or an inaccurate pay table.
  Worsening
economic conditions may adversely affect our business.
  The
demand for entertainment and leisure activities tends to be highly sensitive to
consumers’ disposable incomes, and thus a decline in general economic conditions
or an increase in gasoline prices may lead to our end users having less
discretionary income with which to wager. This situation could cause a reduction
in our revenues and have a material adverse effect on our operating results. The
gaming industry is currently experiencing a period of reduced demand. If, as a
result of deteriorating economic conditions, fewer people gamble in our
customers' facilities, or if amounts spent per person in our customers'
facilities are reduced from historical levels, our business could be materially
and adversely affected.
  Additionally,
a decline in general economic conditions might negatively impact our customers’
abilities to pay us in a timely fashion. Our customers’ failures to make timely
payments could result in an increase in our bad debt provision.
  Our
ability to recognize revenue at the time of sale and delivery is dependent upon
obtaining Vendor-Specific Objective Evidence, or VSOE, for products yet to be
delivered or services yet to be performed.
  We
believe future transactions with existing and future customers may be more
complex than transactions entered into currently. As a result, we may enter into
more complicated business and contractual relationships with customers which, in
turn, can engender increased complexity in the related financial accounting.
Legal and regulatory uncertainty may also affect our ability to recognize
revenue associated with a particular project, and therefore the timing and
possibility of actual revenue recognition may differ from our
forecast.
  -43-
  The
carrying value of our assets in Mexico is dependent upon our ability to
successfully deploy games into Mexico.
  We have
excess player stations not deployed at December 31, 2008, which were
intended to be deployed at facilities in Mexico. If the opening of facilities is
altered negatively, either by significant delay, or by cancellation, the
realizable value of these assets could be reduced. In such instances we may be
required to recognize increased expense on our income statement related to the
impairment of these assets.
  -44-
  ITEM
      2.
              UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS
  None.
  ITEM
      3.
              DEFAULTS
      UPON SENIOR SECURITIES
  None.
  ITEM
      4.
              SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY
HOLDERS
  None
  ITEM
      5.
              OTHER
      INFORMATION
  None.
  ITEM
      6.
              EXHIBITS
  (a)
              Exhibits
  See
Exhibit Index.
  -45-
  SIGNATURES
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
  Date:
      February 9, 2009
              Multimedia
      Games, Inc.By:
              /s/ Randy S. Cieslewicz†Randy
      S. CieslewiczChief
      Financial Officer
  †Mr.
Cieslewicz is signing as an authorized officer and as our Principal Financial
Officer and Principal Accounting Officer.
  -46-
  EXHIBIT
INDEX
  EXHIBIT NO.
                          
                          TITLE
                          
                          LOCATION3.1
                          
                          
                          Amended
      and Restated Articles of Incorporation
                          
                          (1)3.2
                          
                          
                          Amendment
      to Articles of Incorporation
                          
                          (2)3.3
                          
                          
                          Second
      Amended and Restated Bylaws, as Amended
                          
                          (3)10.1
                          
                          
                          First
      Amendment to Anthony M. Sanfilippo Executive Employment
      Agreement
                          
                          (4)10.2
                          
                          
                          First
      Amendment to Uri L. Clinton Executive Employment Agreement
                          
                          (4)10.3
                          
                          
                          First
      Amendment to Virginia E. Shanks Executive Employment
    Agreement
                          
                          (4)10.4
                          
                          
                          First
      Amendment to Patrick J. Ramsey Executive Employment
    Agreement
                          
                          (4)31.1
                          
                          
                          Certification
      of Principal Executive Officer,pursuant
      to Section 302 of the Sarbanes Oxley Act of 2002
                          
                          (*)31.2
                          
                          
                          Certification
      of Principal Accounting Officer,pursuant
      to Section 302 of the Sarbanes Oxley Act of 2002
                          
                          (*)32.1
                          
                          
                          Certification as required by Section 906 ofthe Sarbanes Oxley Act of 2002
                          
                          (*)
 
 (1)
              Incorporated
      by reference to our Form 10-QSB filed with the Securities and Exchange
      Commission, or SEC, for the quarter ended March 31,
    1997.
 (2)
              Incorporated
      by reference to our Form 10-Q filed with the SEC for the quarter ended
      December 31, 2003.
 (3)
              Incorporated
      by reference to our Form 10-K filed with the SEC on
      December 15, 2008.
 (4)
              Filed
      herewith. Executive Employment Agreement Amendments executed to comply
      with Section 409A of the United States Internal Revenue
      Code.
 (*)
              Filed
      herewith.
  -47-