** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

**FORM 10-Q**
| **x**                                                                                                          | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                     |                                                                                          |
| **For the  quarterly period ended December 31, 2005**                                                          |
|                                                                                                           |                                                                                          |
| **OR**                                                                                                         |
|                                                                                                           |                                                                                          |
| **o**                                                                                                          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                     |                                                                                          |
| **For the  transition period from       to      ** |

 

**Commission File Number 0-4281**

**BALLY TECHNOLOGIES, INC.**

(Exact name of registrant as specified in its charter)

 

| **NEVADA**                                             |   | **88-0104066**       |
|--------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                       |   | (I.R.S. Employer     |
| incorporation or  organization)                        |   | Identification  No.) |
|                                                   |   |                 |
| **6601 S.  Bermuda Rd.**                               |   | ** **           |
| **Las  Vegas, Nevada**                                 |   | **89119**            |
| (Address of  principal executive offices)              |   | (Zip Code)           |
| ** **                                             |   | ** **           |
| Registrant’s  telephone number:**(702) 584-7700** |

 

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 ̈  Yes  x  No 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.  (Check one):
|  ̈  Large Accelerated Filer | x  Accelerated Filer |  ̈  Non-Accelerated Filer |
|---------------------------------|---------------------------|------------------------------------|

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act).

 ̈  Yes  x  No

Thenumber of shares of Common Stock, $0.10 par value, outstanding as of December 15,2006, according to the records of the registrant's registrar and transfer agentwas 53,012,913, which does not include 528,648 shares held in treasury.

 

 

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**EXPLANATORY NOTE**

As previously disclosed on Form 12b-25 of Bally Technologies, Inc.(formerly known as Alliance Gaming Corporation, “Bally,” the “Company,” or“we”), filed with the Securities and Exchange Commission (the “SEC”) on February10, 2006, the filing of this Quarterly Report on Form 10-Q for the period endedDecember 31, 2005 was originally delayed due to the significant amount of additionaltime and resources necessary to complete the preparation and analysis of thefinancial statements for the fiscal quarters ended September 30 and December31, 2005.  The filing of this Quarterly Report on Form 10-Q was furtherdelayed by the restatements discussed in our Annual Report on Form 10-K/A forthe fiscal year ended June 30, 2005, as amended and restated and filed with theSEC on October 31, 2006 (the “2005 10-K”). Furthermore, the preparation of the financial information presented inthis Quarterly Report on Form 10-Q required additional time and resourcesbecause it was prepared while certain material weaknesses existed in ourinternal control over financial reporting. 

**INDEX**
| **PART I.**    | ** ** | **FINANCIAL  INFORMATION**                                                                                                                  | ** ** | ** ** |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|           |       |                                                                                                                                        |       |       |
| Item 1.        |       | Financial Statements                                                                                                                        |       |       |
|           |       |                                                                                                                                        |       |       |
|           |       | Unaudited Condensed Consolidated Balance Sheets as of  December 31, 2005 and June 30, 2005                                                  |       |       |
|           |       |                                                                                                                                        |       |       |
|           |       | Unaudited Condensed Consolidated Statements of  Operations for the Three Months and Six Months Ended December 31, 2005 and  2004 (restated) |       |       |
|           |       |                                                                                                                                        |       |       |
|           |       | Unaudited Condensed Consolidated Statements of Cash  Flows for the Six Months Ended December 31, 2005 and 2004 (restated)                   |       |       |
|           |       |                                                                                                                                        |       |       |
|           |       | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                             |       |       |
|           |       |                                                                                                                                        |       |       |
| Item 2.        |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                 |       |       |
|           |       |                                                                                                                                        |       |       |
| Item 3.        |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                 |       |       |
|           |       |                                                                                                                                        |       |       |
| Item 4.        |       | Controls and  Procedures                                                                                                                    |       |       |
|           |       |                                                                                                                                        |       |       |
| **PART  II.**  | ** ** | **OTHER  INFORMATION**                                                                                                                      | ** ** | ** ** |
|           |       |                                                                                                                                        |       |       |
| Item 1.        |       | Legal Proceedings                                                                                                                           |       |       |
|           |       |                                                                                                                                        |       |       |
| Item  6.       |       | Exhibits                                                                                                                                    |       |       |
|           |       |                                                                                                                                        |       |       |
| **SIGNATURES** |       |                                                                                                                                        |

 

1

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** **

**PART I**

**BALLY TECHNOLOGIES, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                      | ** ** | **December 31,**                                                  | ** ** | **June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                      | ** ** | **2005**                                                               | ** ** | **2005**          | ** ** |
| ** **                                                                                                                                      | ** ** | **(in 000s, except  per share amounts)** | ** ** |
| ASSETS                                                                                                                                          |       |                                                                   |       |              |       |
| Current assets:                                                                                                                                 |       |                                                                   |       |              |       |
| Cash and cash  equivalents                                                                                                                      |       | $                                                                      | 24,641     |              | $          | 33,170 |   |
| Restricted cash                                                                                                                                 |       | 14,332                                                                 |       | 13,421            |       |
| Accounts and  notes receivable, net of allowances for doubtful accounts of $9,918 and  $10,340                                                  |       | 121,811                                                                |       | 97,679            |       |
| Inventories                                                                                                                                     |       | 59,015                                                                 |       | 63,523            |       |
| Income taxes  receivable                                                                                                                        |       | 211                                                                    |       | —            |       |
| Deferred tax  assets, net                                                                                                                       |       | 30,848                                                                 |       | 30,884            |       |
| Other current  assets                                                                                                                           |       | 45,913                                                                 |       | 33,034            |       |
| Total current  assets                                                                                                                           |       | 296,771                                                                |       | 271,711           |       |
| Long-term investments  (restricted)                                                                                                             |       | 10,455                                                                 |       | 10,060            |       |
| Long-term receivables,  net of allowance for doubtful accounts of $0 and $11                                                                    |       | 6,585                                                                  |       | 7,450             |       |
| Leased gaming  equipment, net of accumulated depreciation of $57,529 and $42,495                                                                |       | 43,217                                                                 |       | 51,850            |       |
| Property, plant and  equipment, net of accumulated depreciation of $47,470 and $40,548                                                          |       | 67,121                                                                 |       | 66,811            |       |
| Goodwill                                                                                                                                        |       | 160,945                                                                |       | 161,444           |       |
| Intangible assets, net  of accumulated amortization of $21,964 and $17,356                                                                      |       | 46,654                                                                 |       | 49,451            |       |
| Deferred tax assets,  net                                                                                                                       |       | 25,596                                                                 |       | 16,548            |       |
| Other assets, net                                                                                                                               |       | 22,319                                                                 |       | 19,609            |       |
| Total assets                                                                                                                                    |       | $                                                                      | 679,663    |              | $          | 654,934 |   |
|                                                                                                                                            |       |                                                                   |       |              |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                       |       |                                                                   |       |              |       |
| Current liabilities:                                                                                                                            |       |                                                                   |       |              |       |
| Accounts payable                                                                                                                                |       | $                                                                      | 27,897     |              | $          | 36,807 |   |
| Accrued  liabilities                                                                                                                            |       | 52,834                                                                 |       | 43,838            |       |
| Deferred revenue                                                                                                                                |       | 67,370                                                                 |       | 40,962            |       |
| Jackpot  liabilities                                                                                                                            |       | 14,636                                                                 |       | 13,025            |       |
| Income taxes  payable                                                                                                                           |       | —                                                                 |       | 1,752             |       |
| Current  maturities of long-term debt, including $5,037 and $6,006 owed to related  parties                                                     |       | 9,250                                                                  |       | 10,163            |       |
| Total current  liabilities                                                                                                                      |       | 171,987                                                                |       | 146,547           |       |
| Long-term debt, net of  current maturities, including $13,200 and $13,200 owed to related parties                                               |       | 322,832                                                                |       | 324,954           |       |
| Other liabilities                                                                                                                               |       | 18,765                                                                 |       | 6,931             |       |
| Total  liabilities                                                                                                                              |       | 513,584                                                                |       | 478,432           |       |
| Minority interest                                                                                                                               |       | 1,094                                                                  |       | 479               |       |
| Stockholders’ equity:                                                                                                                      |       |                                                                   |       |              |       |
| Special stock,  10,000,000 shares authorized: Series E, $100 liquidation value; 115 shares  issued and outstanding                              |       | 12                                                                     |       | 12                |       |
| Common stock,  $.10 par value; 100,000,000 shares authorized; 52,663,000 and 52,649,000  shares issued and 52,137,00 and 52,123,000 outstanding |       | 5,269                                                                  |       | 5,268             |       |
| Treasury stock  at cost, 526,000 and 526,000 shares                                                                                             |       | (665                                                                   | )          | (665              | )          |
| Deferred  compensation (restricted stock units)                                                                                                 |       | —                                                                 |       | (6,689            | )          |
| Additional  paid-in capital                                                                                                                     |       | 211,579                                                                |       | 212,182           |       |
| Accumulated  other comprehensive income                                                                                                         |       | 1,376                                                                  |       | 1,219             |       |
| Accumulated  deficit                                                                                                                            |       | (52,586                                                                | )          | (35,304           | )          |
| Total  stockholders’ equity                                                                                                                |       | 164,985                                                                |       | 176,023           |       |
| Total liabilities and  stockholders’ equity                                                                                                |       | $                                                                      | 679,663    |              | $          | 654,934 |   |

 

See accompanying notes to unauditedcondensed consolidated financial statements

2

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**BALLY TECHNOLOGIES, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

** **
| ** **                                                                 | ** ** | **Three Months Ended  December 31,**              | ** ** | **Six Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                                         | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | ** **                                                       | ** ** | **(as restated,  see Note 2)**     | ** ** | ** ** | ** ** | **(as restated,  see Note 2)** | ** ** |
| ** **                                                                 | ** ** | **(in 000s, except per share amounts)** | ** ** |
| Revenues:                                                                  |       |                                                             |       |                                              |       |   |   |   |   |
| Gaming equipment and systems                                               |       | $                                                                | 113,961    |                                              | $          | 111,666 |   | $ | 208,756 |   | $ | 218,471 |   |
| Casino operations                                                          |       | 14,492                                                           |       | 12,769                                            |       | 26,047 |   | 25,605 |   |
|                                                                       |       | 128,453                                                          |       | 124,435                                           |       | 234,803 |   | 244,076 |   |
| Costs and  expenses:                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Cost of gaming equipment and systems                                       |       | 65,266                                                           |       | 65,973                                            |       | 114,163 |   | 120,837 |   |
| Cost of casino operations                                                  |       | 4,939                                                            |       | 4,589                                             |       | 9,222 |   | 9,391 |   |
| Selling, general and administrative                                        |       | 47,007                                                           |       | 40,765                                            |       | 88,849 |   | 84,404 |   |
| Research and development costs                                             |       | 10,785                                                           |       | 10,358                                            |       | 21,042 |   | 22,130 |   |
| Restructuring charges                                                      |       | —                                                           |       | —                                            |       | — |   | 1,435 |   |
| Depreciation and amortization                                              |       | 6,951                                                            |       | 5,102                                             |       | 12,824 |   | 9,474 |   |
|                                                                       |       | 134,948                                                          |       | 126,787                                           |       | 246,100 |   | 247,671 |   |
| Operating loss                                                             |       | (6,495                                                           | )          | (2,352)                                           |       | (11,297 | ) | (3,595 | ) |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Other income  (expense):                                                   |       |                                                             |       |                                              |       |   |   |   |   |
| Interest income                                                            |       | 589                                                              |       | 1,046                                             |       | 1,492 |   | 1,857 |   |
| Interest expense                                                           |       | (7,272                                                           | )          | (3,790                                            | )          | (13,204 | ) | (7,752 | ) |
| Loss on extinguishment of debt                                             |       | —                                                           |       | (564)                                             |       | — |   | (564 | ) |
| Other, net                                                                 |       | (250                                                             | )          | 495                                               |       | (521 | ) | 815 |   |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Loss from  continuing operations before income taxes and minority interest |       | (13,428                                                          | )          | (5,165                                            | )          | (23,530 | ) | (9,239 | ) |
| Income tax benefit                                                         |       | 4,702                                                            |       | 2,901                                             |       | 8,835 |   | 4,580 |   |
| Minority interest                                                          |       | (177                                                             | )          | (1,145                                            | )          | (2,587 | ) | (1,644 | ) |
| Loss from  continuing operations                                           |       | (8,903                                                           | )          | (3,409                                            | )          | (17,282 | ) | (6,303 | ) |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Gain (loss) from  discontinued operations, net of income taxes             |       | —                                                           |       | 15                                                |       | — |   | (4,376 | ) |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Net loss                                                                   |       | $                                                                | (8,903     | )                                                 | $          | (3,394 | ) | $ | (17,282 | ) | $ | (10,679 | ) |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Basic and  diluted loss per share:                                         |       |                                                             |       |                                              |       |   |   |   |   |
| Continuing operations                                                      |       | $                                                                | (0.17      | )                                                 | $          | (0.07 | ) | $ | (0.33 | ) | $ | (0.12 | ) |
| Discontinued operations                                                    |       | —                                                           |       | —                                            |       | — |   | (0.09 | ) |
| Total                                                                      |       | $                                                                | (0.17      | )                                                 | $          | (0.07 | ) | $ | (0.33 | ) | $ | (0.21 | ) |
|                                                                       |       |                                                             |       |                                              |       |   |   |   |   |
| Weighted average  shares outstanding:                                      |       |                                                             |       |                                              |       |   |   |   |   |
| Basic and  diluted                                                         |       | 52,138                                                           |       | 51,010                                            |       | 52,138 |   | 50,988 |   |

 

See accompanying notes to unauditedcondensed consolidated financial statements.

3

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**BALLY TECHNOLOGIES, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                 | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | ** **                                        | ** ** | **(as restated,  see Note 2)** | ** ** |
| ** **                                                                                 | ** ** | **(in 000s)**                                | ** ** |
| Cash flows from  operating activities:                                                     |       |                                              |       |   |   |
| Net loss                                                                                   |       | $                                                 | (17,282    | ) | $ | (10,679 | ) |
| Loss from  discontinued operations                                                         |       | —                                            |       | 4,376 |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                              |       | 30,938                                            |       | 22,784 |   |
| Share-based compensation                                                                   |       | 5,914                                             |       | 542 |   |
| Loss of extinguishment of debt                                                             |       | —                                            |       | 564 |   |
| Deferred income tax expense (benefit)                                                      |       | (9,012                                            | )          | 3,466 |   |
| Provision for doubtful accounts                                                            |       | 680                                               |       | 4,804 |   |
| Operating activities of discontinued operations                                            |       | —                                            |       | (2,997 | ) |
| Inventory and other assets write-downs                                                     |       | 7,983                                             |       | 14,602 |   |
| Other                                                                                      |       | 6,960                                             |       | (2,721 | ) |
| Changes in  operating assets and liabilities:                                              |       |                                              |       |   |   |
| Purchase of appeal bond                                                                    |       | —                                            |       | (7,361 | ) |
| Accounts and notes receivable                                                              |       | (23,809                                           | )          | 24,905 |   |
| Inventories                                                                                |       | 4,446                                             |       | (21,471 | ) |
| Other current assets                                                                       |       | 3,656                                             |       | 3,010 |   |
| Accounts payable                                                                           |       | (8,847                                            | )          | (7,169 | ) |
| Accrued liabilities, deferred revenue and jackpot  liabilities                             |       | 21,540                                            |       | (30,917 | ) |
| Net cash  provided by (used in) operating activities                                       |       | 23,167                                            |       | (4,262 | ) |
|                                                                                       |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                     |       |                                              |       |   |   |
| Additions to property, plant, and equipment                                                |       | (6,246                                            | )          | (5,471 | ) |
| Additions to leased gaming equipment                                                       |       | (19,933                                           | )          | (18,043 | ) |
| Settlement of acquisition related contingency                                              |       | —                                            |       | (12,000 | ) |
| Acquisition, net of cash acquired                                                          |       | —                                            |       | 1,911 |   |
| Restricted cash and investments                                                            |       | (866                                              | )          | 635 |   |
| Additions to other long-term assets                                                        |       | (1,804                                            | )          | (1,521 | ) |
| Net cash used in  investing activities                                                     |       | (28,849                                           | )          | (34,489 | ) |
|                                                                                       |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                     |       |                                              |       |   |   |
| Capitalized debt issuance costs                                                            |       | —                                            |       | (1,038 | ) |
| Payoff of debt due to sale of net assets of  discontinued operations                       |       | —                                            |       | (101,618 | ) |
| Reduction of long-term debt                                                                |       | (3,042                                            | )          | (2,050 | ) |
| Purchase of treasury shares                                                                |       | —                                            |       | (164 | ) |
| Proceeds from exercise of stock options, including  tax benefit                            |       | 172                                               |       | 945 |   |
| Net cash used in  financing activities                                                     |       | (2,870                                            | )          | (103,925 | ) |
|                                                                                       |       |                                              |       |   |   |
| Effect of  exchange rate changes on cash                                                   |       | 23                                                |       | 487 |   |
|                                                                                       |       |                                              |       |   |   |
| Cash and cash  equivalents:                                                                |       |                                              |       |   |   |
| Decrease for period                                                                        |       | (8,529                                            | )          | (142,189 | ) |
| Balance, beginning of period                                                               |       | 33,170                                            |       | 154,258 |   |
| Balance, end of  period                                                                    |       | $                                                 | 24,641     |   | $ | 12,069 |   |

 

See accompanying notes to unaudited condensed consolidated financialstatements.

 

4

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**BALLY TECHNOLOGIES, INC.**

**FORM 10-Q**

Notes to Unaudited Condensed Consolidated Financial Statements

**1.             BASIS OFPRESENTATION**

*Principles of presentation and consolidation*

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with generally accepted accounting principlesand pursuant to the rules and regulations of the Securities and ExchangeCommission (the “SEC”) and reflect all adjustments, consisting of normalrecurring adjustments, which management believes are necessary to fairlypresent the financial position, results of operations and cash flows of BallyTechnologies, Inc. (formerly known as Alliance Gaming Corporation), a Nevadacorporation, and its subsidiaries (“Bally” or the “Company”) for the respectiveperiods presented.  The results ofoperations for an interim period are not necessarily indicative of the resultsthat may be expected for any other interim period or the year as a whole. Theaccompanying unaudited condensed consolidated financial statements should beread in conjunction with the consolidated financial statements and notesthereto in the Company's Annual Report on Form 10-K/A for the fiscal year endedJune 30, 2005 as amended and restated and filed with the SEC on October 31,2006 (the “2005 10-K”). 

Bally is a diversified, worldwide gaming company thatdesigns, manufactures and distributes gaming machines and computerized monitoringsystems for gaming machines and owns and operates one casino. 

The Company is thegeneral partner of Rainbow Casino Vicksburg Partnership (“RCVP”), whichoperates the Rainbow Casino in Vicksburg, Mississippi.  Pursuant to transactions consummated in March1995, the Rainbow Corporation, which was the former general partner of RCVP,became a limited partner entitled to receive 10% of the net available cashflows of RCVP after debt service and other items, as defined in the limitedpartnership agreement, which amount increases to 20% of such amount for theproportional revenues that exceed $35.0 million each year through December 31,2010.  The Company holds the remainingeconomic interest in the partnership. The Company announced in October 2006 that it is evaluating alternativeswith respect to the possible sale of the Rainbow Casino.  As of the date of this filing, a formal planfor the sale of had not been approved by the Company’s Board of Directors.

The Companyconsolidates RCVP and records an adjustment to reflect the portion of theearnings of RCVP attributable to the minority shareholders.

The Company also consolidates certain Atlantic Cityprogressive trusts in accordance with Financial Accounting Standards Board(“FASB”) Interpretation (“FIN”) 46R, *Consolidation of VariableInterest Entities,*which addresses consolidation by abusiness enterprise of variable interest entities (“VIE’s”) that either: (1) donot have sufficient equity investment at risk to permit the entity to financeits activities without additional subordinated financial support or (2) hold asignificant variable interest in, or have significant involvement with, anexisting VIE.   For the three and six month periodsended December 31, 2005, the Company consolidated $1.7 million and $4.3million, respectively, in revenues and $2.3 million and $3.2 million,respectively in related expenses, as well as $6.1 million in total assets andliabilities as of December 31, 2005, primarily consisting of restricted cashaccounts and restricted investments (included in other assets in the condensedconsolidated balance sheets) and related jackpot liabilities. The Atlantic Cityprogressive trusts were not consolidated for the three and six months endedDecember 31, 2004.

All significant intercompanyaccounts and transactions have been eliminated in consolidation.  

*Reclassifications*

Certain reclassifications havebeen made to the prior period financial statements to conform to the currentperiod presentation, the most significant of which was depreciation on leasedgaming equipment which has been reclassified from depreciation expense to costof gaming equipment and systems, totaling $6.9 million and $13.3 million,respectively, for the three and six month periods ended December 31, 2004.  

*Inventories*

Inventories are stated atthe lower of cost, determined on a first in, first out basis, or market.  Cost elements included in work-in-process andfinished goods include raw materials, freight, direct labor and manufacturingoverhead.

 

5

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The Company recordedinventory write-downs totaling approximately $8.0 million and $14.6 millionrespectively, during the six months ended December 31, 2005 and 2004.  These charges are classified in cost ofgaming equipment and systems in the consolidated statements of operations.

*Property, plant and equipment and leased gamingequipment*

The Company historically depreciated leased gaming equipment downto its salvage value over estimated useful lives ranging from two to fouryears.

Based on historical data indicating a shortening of the averagelength of time certain leased gaming equipment was deployed, the Companyre-evaluated the useful lives during the quarter ended December 31, 2005,and reduced the depreciable life and salvage values to zeros for certain of itsproducts to two years and recorded the change in estimate prospectively.  This change in estimate resulted in a $6.8million charge to depreciation expense in the three and six month periods endedDecember 31, 2005.

*Recently Issued AccountingPronouncements*

In September 2006,the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements*, which defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.SFAS No. 157 does not require any new fair value measurements, rather itapplies under existing accounting pronouncements that require or permit fairvalue measurements.  SFAS No. 157 iseffective for fiscal years beginning after November 15, 2007, and accordingly,the Company expects to adopt SFAS No. 157 beginning in fiscal year 2009. TheCompany is currently in the process of evaluating the impact SFAS No. 157 willhave on its consolidated results of operations, financial position and cashflows.

In September 2006,the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*, providing guidance on how prioryear misstatements should be taken into consideration when quantifyingmisstatements in current year financial statements for purposes of determiningwhether the current year's financial statements are materially misstated. SAB No.108 is effective for fiscal years ending on or after November 15, 2006, andaccordingly, the Company expects to adopt SAB No. 108 beginning in fiscal year2007. The Company does not expect SAB No. 108 will have an impact on its consolidatedresults of operations, financial position or cash flows.

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

In June 2005,the FASB issued FASB Staff Position (“FSP”) No. FAS 143-1, *Accounting for Electronic Equipment WasteObligations,* toaddress accounting for obligations associated with the European Union’sDirective 2002/96/EC on Waste Electrical and Electronic Equipment. TheDirective, enacted in 2003, requires EU-member countries to adopt legislationto regulate the collection, treatment, recovery, and environmentally sounddisposal of electrical and electronic waste equipment. The Directivedistinguishes between products put on the market after August 13, 2005 asnew waste and before that date as historical waste. FSP No. FAS 143-1 onlyaddresses accounting for historical waste and is required to be applied thelater of the first reporting period ending after June 8, 2005 or the dateof adoption of the law by the applicable European Union member country.   Adoption of FSP No. FAS 143-1 did not have amaterial impact on the Company’s consolidated results of operations, financialposition or cash flows.

6

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InDecember 2004, the FASB issued SFAS No. 153, *Exchanges of Nonmonetary Assets*,amending APB Opinion No. 29, *Accounting forNonmonetary Transactions*.  APBOpinion No. 29 treated nonmonetary exchanges of similar productive assets as anexception from fair value measurement. SFAS No. 153 replaces this exception with a general exception from fairvalue measurement for exchanges of nonmonetary assets that do not have commercialsubstance. Nonmonetary exchanges have commercial substance if the future cashflows of an entity are expected to change significantly as a result of theexchange. SFAS No. 153 was effective for nonmonetary asset exchanges occurringin fiscal years beginning after June 15, 2005. Adoption of SFAS No. 153did not have a material impact on the Company’s consolidated results ofoperations, financial position or cash flows.

In November 2004, the FASB issuedSFAS No. 151, *Inventory Costs*,revising Accounting Research Bulletin No. 43, Chapter 4, *Inventory Pricing*, which clarifies theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and wasted material. SFAS No. 151 was effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  Adoption of SFAS No. 151 did not have amaterial impact on the Company’s consolidated results of operations, financialposition or cash flows.

**2.             RESTATEMENT**

Subsequent to the issuance of the unaudited condensed consolidated financialstatements for the three and six month periods ended December 31, 2004, theCompany identified accounting errors that required adjustments to such previouslyissued financial statements.  

These errors relatedprimarily to revenue recognition, accounting for inventory costs and other miscellaneousitems as discussed below.

*Revenue Recognition*

The Company identified instances where the timing or amount ofrevenue recognized was not in accordance with The American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) No. 97-2 *Software Revenue Recognition*.  The Company determined that certainrequirements of SOP No. 97-2 were not met in a number of instances andtherefore, revenue with respect to certain transactions was recognizedprematurely.  In accounting for thesetransactions, the Company has determined that it (1) should have deferred therevenue and related cost of sales, (2) should have reflected certain goodsshipped as consigned inventory until later periods and (3) should not haverecognized certain accounts receivable until later periods.

The specific circumstances which resulted in adjustments are asfollows:

*Persuasive evidence of an arrangement exists*

The Company identified a number of transactions for which certainconditions under the terms of the original agreement were not met or for whichan agreement could not be found, calling into question whether the originalagreement or lack thereof, provided adequate evidence of an arrangement thatwas sufficiently definitive to support revenue recognition.  The Company concluded there was notpersuasive evidence of an arrangement at that time and, consequently, revenueshould have been deferred until the cash was received.

Additionally, the Company identified one transaction for whichrevenue was recognized in the fiscal quarter ended December 31, 2004 at thetime the games were shipped to the customer based on a signed sales-type leaseagreement.  Subsequently, the customernegotiated a fixed price payment with a cash discount and other concessions. Thesecircumstances called into question whether the original agreement providedadequate evidence of an arrangement that was sufficiently definitive to supportrecognition of revenue in December 2004. The Company has concluded that there was not persuasive evidence of anarrangement at that time, and therefore, the revenue should have been deferreduntil the cash was received in July 2005.

7

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*Delivery has occurred*

TheCompany identified instances in which revenue was recognized for sales at thetime the product was shipped to customers when the shipping terms stated orimplied that the risk of loss and/or title did not transfer until the goodswere delivered to the customer’s location. Furthermore, certain transactions were identified that had beenaccounted for on a bill and hold basis that did not satisfy all of theapplicable bill and hold criteria under SAB No. 104, *RevenueRecognition in Financial Statements*, resulting in revenuerecognition prior to the physical delivery of goods to the customer. In both ofthese circumstances, recognition of revenue should have been deferred until thetime the products reached the customer’s location, and therefore, the revenuethat had been previously recorded in connection with these transactions wasadjusted to be recorded in subsequent accounting periods when the deliverycriteria was met.

TheCompany also identified instances in the System division where certain standardsales agreements contained contractual terms creating a non-perpetual softwarelicense rather than a perpetual license. The Company determined that in such circumstances, revenue fornon-perpetual software licenses should not have been recognized in full as ofthe acceptance date, but rather should have been deferred and recognizedratably over the twelve-month period from the date of acceptance.  Consequently, the revenue that had previouslybeen recorded in connection with these transactions was adjusted to be recordedin the appropriate periods. 

*The vendor’s fee is fixed or determinable and collectibility isprobable*

The use of extendedpayment terms in a software licensing arrangement may indicate that the fee isnot fixed or determinable and collectibility is not probable.  The Company identified instances whererevenue was recorded upon delivery of both systems and gaming products tocustomers under contracts that contained payment terms in excess of 24months.  At the time the sales wererecorded, the Company did not have sufficient historical evidence ofcollections made under extended contracts with terms beyond 24 months, asrequired under SOP No. 97-2.  Therefore,the Company should not have concluded that collectibility was probable and itshould have deferred revenue on all contracts with extended payment terms inexcess of 24 months, and recorded revenue upon receipt of payment from thecustomer.  Consequently, the revenue thathad previously been recorded in connection with these transactions was adjustedto be recorded in the subsequent periods when payment was received.   

Inaddition, the Company identified instances in which revenue was recognized atthe time product was shipped to customers who were either thinly capitalized orwere new customers to the Company for which creditworthiness had not been sufficientlyestablished.  Pursuant to SOP No. 97-2,collectibility must be determined to be “probable” at the time of delivery inorder for revenue to be recognized, and therefore, in such circumstancesrecognition of revenue should have been deferred until payment from thecustomer was received.  Therefore,revenue that had previously been recorded for these transactions was adjustedto be recorded in subsequent periods when payment was received.

Inventory

In certain circumstances,standard versus actual raw material costs were recorded in cost of sales ratherthan as adjustments to inventory and fixed assets.  As a result, adjustments have been made toadjust the standard costs to actual costs, resulting in corrections to thecarrying value of certain finished goods and fixed assets and related cost ofsales and depreciation expense.

Other MiscellaneousAdjustments

The Companydetermined that it should have presented the cash flows from discontinuedoperations within the respective categories of operating, investing andfinancing activities in its statements of cash flows, rather than as a singleline item. The statement of cash flows was also adjusted to reflect a change inthe classification of the jackpot reserve cash accounts to restricted cash.

The Company alsodetermined that certain balance sheet account reconciliations were notperformed timely and therefore necessary adjustments were not identified orrecorded timely.  The Company hascompleted the account reconciliations and made the corresponding corrections tothe unaudited condensed consolidated financialstatements. 

8

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The Companydetermined that is should have recorded the value of restricted stock unitsbased on the closing price of its common stock on the date of grant and not theaverage closing price for the 20 business days prior to the date ofgrant.  An adjustment was recorded to reflect the fair market value duringthe fiscal year ended June 30, 2005, based on the closing price of theCompany’s common stock on the respective dates of grant of the restricted stockunits and an adjustment was recorded during the three and six month periodsended December 31, 2004 for the related stock compensation expense.

Additionally, theCompany determined that interest earned on trade accounts receivable shouldhave been recorded as interest income rather than revenue and recorded anadjustment to change the classification of these amounts to interest income. 

As a result, the unauditedcondensed consolidated financial statements for the three and six month periodsended December 31, 2004 have been restated from amounts previously reported. Thefollowing is a reconciliation of the loss from continuing operations aspreviously reported to the restated amounts by the categories discussed above, netof tax:
| ** **                                               | ** ** | **For the Three Months Ended  December 31, 2004** | ** ** | **For the Six Months Ended  December 31, 2004** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **(in 000s)**                                                              | ** ** |
| Loss from  continuing operations, as previously reported |       | $                                                                               | (7,540     | )                                                                             | $          | (13,945 | ) |
| Revenue recognition adjustments, net                     |       | 3,277                                                                           |       | 6,326                                                                         |       |
| Inventory adjustments, net                               |       | 335                                                                             |       | 641                                                                           |       |
| Other miscellaneous adjustments, net                     |       | 519                                                                             |       | 675                                                                           |       |
| Loss from continuing  operations, as restated            |       | $                                                                               | (3,409     | )                                                                             | $          | (6,303 | ) |

 

Thefollowing tables summarize the significant effects of the restatement:
| ** **                                                                 | ** ** | **Three Months Ended  December 31, 2004** | ** ** | **Six Months Ended  December 31, 2004** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As previously  reported**                              | ** ** | **As restated**                                        | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
| ** **                                                                 | ** ** | **(in 000s)**                                            | ** ** |
| *Statement  of Operations*                                                 |       |                                                          |       |                                                        |       |   |   |   |   |
| Revenue:                                                                   |       |                                                          |       |                                                        |       |   |   |   |   |
| Gaming equipment and systems                                               |       | $                                                             | 100,933    |                                                        | $          | 111,666 |   | $ | 205,010 |   | $ | 218,471 |   |
| Casino operations                                                          |       | 12,769                                                        |       | 12,769                                                      |       | 25,605 |   | 25,605 |   |
| Total revenue                                                              |       | 113,702                                                       |       | 124,435                                                     |       | 230,615 |   | 244,076 |   |
| Cost of gaming  equipment and systems                                      |       | 53,337                                                        |       | 65,973                                                      |       | 104,173 |   | 120,837 |   |
| Selling, general  and administrative expense                               |       | 41,051                                                        |       | 40,765                                                      |       | 84,706 |   | 84,404 |   |
| Depreciation and  amortization (1)                                         |       | 12,020                                                        |       | 5,102                                                       |       | 22,861 |   | 9,474 |   |
| Operating loss                                                             |       | (7,653                                                        | )          | (2,352                                                      | )          | (14,081 | ) | (3,595 | ) |
| Interest income                                                            |       | 318                                                           |       | 1,046                                                       |       | 798 |   | 1,857 |   |
| Interest expense                                                           |       | 3,750                                                         |       | 3,790                                                       |       | 7,712 |   | 7,752 |   |
| Loss from  continuing operations before income taxes and minority interest |       | (11,274                                                       | )          | (5,165                                                      | )          | (21,031 | ) | (9,239 | ) |
| Income tax  benefit                                                        |       | 4,879                                                         |       | 2,901                                                       |       | 8,730 |   | 4,580 |   |
| Loss from  continuing operations                                           |       | (7,540                                                        | )          | (3,409                                                      | )          | (13,945 | ) | (6,303 | ) |
| Net loss                                                                   |       | (7,525                                                        | )          | (3,394                                                      | )          | (18,321 | ) | (10,679 | ) |
|                                                                       |       |                                                          |       |                                                        |       |   |   |   |   |
| Basic and  diluted loss per share:                                         |       |                                                          |       |                                                        |       |   |   |   |   |
| Continuing operations                                                      |       | $                                                             | (0.15      | )                                                           | $          | (0.07 | ) | $ | (0.27 | ) | $ | (0.12 | ) |
| Discontinued operations                                                    |       | —                                                        |       | —                                                      |       | (0.09 | ) | (0.09 | ) |
| Total                                                                      |       | $                                                             | (0.15      | )                                                           | $          | (0.07 | ) | $ | (0.36 | ) | $ | (0.21 | ) |

 

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(1)          Depreciation on leased gaming equipment has beenreclassified to cost of gaming equipment and systems (see Note 1).

9

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|                                                 | ** ** | **Six Months Ended  December 31, 2004** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                      | ** ** | **As previously  reported**                            | ** ** | **As restated** | ** ** |
| ** **                                      | ** ** | **(in 000s)**                                          | ** ** |
| *Statement  of Cash Flows*                      |       |                                                        |       |   |   |
| Cash flows used  in operating activities        |       | $                                                           | (7,704     | ) | $ | (4,262 | ) |
| Cash flows used  in investing activities        |       | (35,324                                                     | )          | (34,489 | ) |
| Cash flows used  in financing activities        |       | (103,925                                                    | )          | (103,925 | ) |
| Cash flows provided by  discontinued operations |       | 1,704                                                       |       | — |   |
|                                                 |            |                                                             |            |  |  |  |  |

 

**3.             DISCONTINUED OPERATIONS**

The Companycompleted the sale of United Coin Machine Co. (“United Coin”) in June 2004 andVideo Service Inc. (“VSI”) in October 2004.

The results of these discontinued operationsare presented net of applicable income taxes within loss from discontinuedoperations in the accompanying condensed consolidated statements of operations.

During the three month period ended December31, 2004, a Federal District Court jury reached a verdict in a patentinfringement case filed by Action Gaming, Inc. (“AGI”) and International GameTechnology (“IGT”). The jury awarded AGI and IGT an aggregate of approximately$7.4 million in damages related to a single, optional feature offered incertain multi-hand poker games provided solely by United Coin.   See Note 13, Commitments and Contingencies,for a description of the related litigation.

Operating results for the discontinuedoperations include VSI and United Coin. Summary operating results are as follows:   
|                                              | ** ** | **Three Months Ended  December 31, 2004** | ** ** | **Six Months Ended  December 31, 2004** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(in 000s)**                                            | ** ** |
| Net revenues                                 |       | $                                                             | 559        |                                                        | $          | 4,514 |   |
| Operating income  (loss)                     |       | (129                                                          | )          | 358                                                         |       |
| Loss on  litigation settlement, Nevada Route |       | —                                                        |       | (7,356                                                      | )          |
| Income tax  benefit                          |       | 38                                                            |       | 2,516                                                       |       |
| Income (loss) from  discontinued operations  |       | $                                                             | 15         |                                                        | $          | (4,376 | ) |

 

**4.       EARNINGS PER SHARE**

The computation of basic and diluted loss per share from continuingoperations and discontinued operations and loss applicable to common shares areas follows:
|                                             | ** ** | **Three Months Ended  December 31,**              | ** ** | **Six Months Ended  December 31,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                                         | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(in 000s, except per share amounts)** | ** ** |
| Loss from  continuing operations            |       | $                                                                | (8,903     | )                                                 | $          | (3,409 | ) | $ | (17,282 | ) | $ | (6,303 | ) |
| Income (loss)  from discontinued operations |       | —                                                           |       | 15                                                |       | — |   | (4,376 | ) |
| Net loss                                    |       | $                                                                | (8,903     | )                                                 | $          | (3,394 | ) | $ | (17,282 | ) | $ | (10,679 | ) |
|                                        |       |                                                             |       |                                              |       |   |   |   |   |
| Weighted average  common shares outstanding |       | 52,138                                                           |       | 51,010                                            |       | 52,138 |   | 50,988 |   |
|                                        |       |                                                             |       |                                              |       |   |   |   |   |
| Loss per basic  and diluted share:          |       |                                                             |       |                                              |       |   |   |   |   |
| Continuing operations                       |       | $                                                                | (0.17      | )                                                 | $          | (0.07 | ) | $ | (0.33 | ) | $ | (0.12 | ) |
| Discontinued operations                     |       | —                                                           |       | —                                            |       | — |   | (0.09 | ) |
| Total                                       |       | $                                                                | (0.17      | )                                                 | $          | (0.07 | ) | $ | (0.33 | ) | $ | (0.21 | ) |

 

10

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Certainsecurities were excluded from the diluted loss per share calculation becausetheir inclusion would be anti-dilutive due to the reported net loss.  Suchsecurities consist of the following:
|                         | ** ** | **Three and Six Months Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                                              | ** ** | **2004** | ** ** |
| ** **              | ** ** | **(in 000s)**                                                    | ** ** |
| Stock options           |       | 9,147                                                                 |       | 6,185 |   |
| Warrants                |       | 100                                                                   |       | 100 |   |
| Restricted stock  units |       | 554                                                                   |       | 534 |   |
| Total                   |       | 9,801                                                                 |       | 6,819 |   |

 

Asof December 31, 2005 and 2004, the Company also had certain related party debtoutstanding which is convertible into common stock at the Company’s discretion,the potential dilution from which has not been included in the diluted loss pershare computation due to the reported net loss. Assuming the conversion occurred on December 31, 2005 and 2004, 1.1million and 2.2 million shares would have been outstanding as a result of theconversion.

**5.             SHARE-BASED COMPENSATION**

In December 2001, theCompany’s shareholders approved the 2001 Long-Term Incentive Plan, which hasbeen amended several times (the “2001 Plan”). The 2001 Plan provides for theissuance of up to 10,550,000 shares (as amended in fiscal year 2005) of commonstock to Company employees, directors and designated paid consultants and up to900,000 shares of restricted stock or restricted stock units (“RSUs”).Generally, options are granted at the fair value of the Company’s common stockat the date of grant and are exercisable over five to ten years.

OnJune 13, 2005, the Board of Directors of the Company approved the acceleratedvesting of unvested stock options held by the Company’s employees, officers anddirectors with an exercise price of $15.00 or higher.  This accelerated vesting affected options forapproximately 2.4 million shares of the Company’s common stock.  In order to prevent unintended personalbenefits to individuals resulting from the accelerated vesting of options, theCompany imposed sales restrictions on shares acquired upon exercise of theseoptions that parallel the vesting requirements of the original options.

Thedecision to accelerate vesting of these underwater stock options was madeprimarily to avoid recognizing compensation expense under SFAS No. 123R.  Because the exercise price of the optionssubject to the accelerated vesting was above the market price of the stock on thedate of acceleration, the Company determined that these options did not offer asufficient incentive to employees when compared to the potential futurecompensation expense that the Company would incur under SFAS No. 123R withrespect to these options.

Effective July 1,2005, the Company adopted the provisions of SFAS No. 123R whichestablished accounting for equity instruments exchanged for employee services.SFAS No. 123R, *Share Based Payment*, requiresemployee stock options and rights to purchase shares under stock participationplans to be accounted for under the fair value method, and eliminates theability to account for these instruments under the intrinsic value methodprescribed by Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*.  In March 2005, the SEC issued SAB No. 107,  *Share-Based Payment,*whichprovided interpretive guidance on SFAS No. 123R valuation methods, assumptionsused in valuation models, and the interaction of SFAS No. 123R with existingSEC guidance. SAB No. 107 also requires the classification of share-basedcompensation expense in the same financial statement line as cash compensation,and therefore, impacted the Company’s cost of gaming equipment and systems,casino operations (and related gross profits and margins), research anddevelopment costs, and selling, general and administrative expenses.  The Company implemented SFAS No. 123R on July1, 2005 using the modified-prospective method.

Under the provisions ofSFAS No. 123R, share-based compensation cost is measured at the grantdate, based on the 

11

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calculated fair value ofthe award, and is recognized as an expense over the employee’s requisiteservice period (generally the vesting period of the equity grant). Prior toJuly 1, 2005, the Company accounted for share-based compensation toemployees in accordance with APB Opinion No. 25 and relatedinterpretations. The Company also followed the disclosure requirements ofSFAS No. 123, *Accounting for Stock-BasedCompensation*, as amended by SFAS No. 148, *Accountingfor Stock-Based Compensation—Transition and Disclosure*. The Companyelected to adopt SFAS No. 123R using the modified prospective transitionmethod, and accordingly, financial statement amounts for the prior periodspresented have not been restated to reflect the fair value method of expensingshare-based compensation.

The following tablepresents share-based compensation expense included in the Company’s condensedconsolidated statement of operations: 
|                                              | ** ** | **Three Months Ended  December 31, 2005** | ** ** | **Six Months Ended  December 31, 2005** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(in 000s)**                                            | ** ** |
| Selling, general  and administrative         |       | $                                                             | 2,882      |                                                        | $          | 5,372 |   |
| Research and  development                    |       | 265                                                           |       | 496                                                         |       |
| Cost of gaming  and equipment                |       | 25                                                            |       | 46                                                          |       |
| Share-based  compensation expense before tax |       | 3,172                                                         |       | 5,914                                                       |       |
| Income tax benefit                           |       | 1,110                                                         |       | 2,069                                                       |       |
| Net share-based  compensation expense        |       | $                                                             | 2,062      |                                                        | $          | 3,845 |   |

 

Included in share-basedcompensation expense in the condensed consolidated statements of cash flows forthe six month period ended December 31, 2005, is $1.8 million of restrictedstock unit amortization.

As of December 31, 2005there was $22.7 million of total unrecognized compensation expense related tothe nonvested stock options which will be recognized over the next 4.5 years.

The Company estimates thefair value of stock options using the Black-Scholes valuation model. Key inputassumptions used to estimate the fair value of stock options include theexercise price of the award, the expected option term, the expected volatilityof the Company’s common stock over the option’s expected term, the risk-freeinterest rate over the option’s expected term, and the Company’s expectedannual dividend yield. The Company believes that the valuation technique andthe approach utilized to develop the underlying assumptions are appropriate incalculating the fair values of the Company’s stock options granted. Estimatesof fair value are not intended to predict actual future events or the valueultimately realized by persons who receive equity awards.

The fair value of eachoption granted during the corresponding period was estimated on the grant dateusing the Black-Scholes option-pricing model with the following assumptions:
|                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                            | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted  Average:                  |       |                                                |       |                                              |       |   |   |   |   |
| Expected option term (in years) (1) |       | 6.25                                                |       | 6.25                                              |       | 6.37 |   | 6.25 |   |
| Expected volatility factor          |       | 61.56                                               | %          | 62.00                                             | %          | 62.01 | % | 62.00 | % |
| Risk-free interest rate             |       | 4.18                                                | %          | 3.50                                              | %          | 3.74 | % | 3.50 | % |
| Expected annual  dividend yield     |       | —                                              | %          | —                                            | %          | — | % | — | % |

 

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(1)          The option term wasdetermined using the short-cut method for estimating expected option life.

12

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Current periodstock option activity as of and for the six months ended December 31, 2005 issummarized below:
|                                              | ** ** | **Weighted Average** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **Shares**                | ** ** | **Exercise  Price** | ** ** | **Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| ** **                                   | ** ** | **(in 000s)**        | ** ** | **(per share)** | ** ** | **(years)** | ** ** | **(in 000s)** | ** ** |
| Balance  outstanding as of June 30, 2005     |       | 8,196                     |       | $ | 14.72 |   |   |   | $ | 18,224 |   |
| Granted                                      |       | 1,213                     |       | 13.51 |   |   |   |   |   |
| Exercised                                    |       | (14                       | )          | 12.20 |   |   |   |   |   |
| Forfeited or expired                         |       | (248                      | )          | 19.29 |   |   |   |   |   |
| Balance  outstanding as of December 31, 2005 |       | 9,147                     |       | $ | 14.44 |   | 6.53 |   | $ | 14,757 |   |
|                                         |       |                      |       |   |   |   |   |   |   |
| Exercisable as of  December 31, 2005         |       | 5,218                     |       | $ | 16.14 |   | 5.28 |   | $ | 10,031 |   |

 

Current periodrestricted stock and RSU activity as of and for the six months ended December31, 2005 is summarized below:
| ** **                                   | ** ** | ** **         | ** ** | **Weighted Average**        | ** ** |
|----------------------------------------------|------------|--------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **Shares**         | ** ** | **Grant  Date Fair  Value** | ** ** |
| ** **                                   | ** ** | **(in 000s)** | ** ** | **(per share)**             | ** ** |
| Balance  outstanding as of June 30, 2005     |       | 554                |       | $                                | 15.87      |   |
| Granted                                      |       | —             |       | —                           |       |
| Exercised                                    |       | —             |       | —                           |       |
| Forfeited or expired                         |       | —             |       | —                           |       |
| Balance  outstanding as of December 31, 2005 |       | 554                |       | $                                | 15.87      |   |
|                                         |       |               |       |                             |       |
| Exercisable as of  December 31, 2005         |       | 214                |       | $                                | 15.50      |   |

 

The following isadditional information about stock options exercised, granted and vested duringthe period:
|                                                        | ** ** | **Three Months Ended  December 31,**              | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                                         | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in 000s, except per share amounts)** | ** ** |
| Weighted average  fair value per share:                |       |                                                             |       |                                              |       |   |   |   |   |
| Options granted                                        |       | $                                                                | 7.73       |                                              | $          | 7.03 |   | $ | 8.33 |   | $ | 7.86 |   |
| Options vested                                         |       | $                                                                | 7.54       |                                              | $          | 8.03 |   | $ | 7.90 |   | $ | 8.41 |   |
|                                                   |       |                                                             |       |                                              |       |   |   |   |   |
| Exercises under  all share-based payment arrangements: |       |                                                             |       |                                              |       |   |   |   |   |
| Total intrinsic value                                  |       | $                                                                | —     |                                              | $          | 231.9 |   | $ | 36.0 |   | $ | 1,093.0 |   |
| Cash received                                          |       | $                                                                | —     |                                              | $          | 72.5 |   | $ | 176.2 |   | $ | 708.0 |   |
| Tax benefit  realized                                  |       | $                                                                | —     |                                              | $          | 179.6 |   | $ | 30.9 |   | $ | 854.1 |   |

 

Prior to July 1, 2005,the Company accounted for share-based compensation to employees in accordancewith APB Opinion No. 25, and accordingly, did not recognize compensationexpense for employee share-based awards for the three and six month periodsended December 31, 2004, as the exercise price of the Company’s employee stockawards equaled the market price of the underlying stock on the date of grant.

The Company hadpreviously adopted the provisions of SFAS No. 123, as amended by SFASNo. 148 through disclosure only. The following table illustrates theeffects on net loss and loss per share for the three months ended December 31,2004, as if the Company had applied the fair value recognition provisions ofSFAS No. 123 to share-based employee awards:

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|                                                 | ** ** | **Three Months Ended  December 31, 2004**    | ** ** | **Six Months Ended  December 31, 2004** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                      | ** ** | **(in 000s, except per share amounts)** | ** ** |
| Reported net  loss                              |       | $                                                                | (3,394     | )                                                           | $          | (10,679 | ) |
| Reported  share-based compensation, net of tax  |       | 412                                                              |       | 412                                                         |       |
| Pro forma  share-based compensation, net of tax |       | (2,143                                                           | )          | (3,830                                                      | )          |
| Pro forma net  loss                             |       | $                                                                | (5,125     | )                                                           | $          | (14,097 | ) |
| Basic and  diluted loss per share:              |       |                                                             |       |                                                        |       |
| As reported                                     |       | $                                                                | (0.07      | )                                                           | $          | (0.21 | ) |
| Pro forma                                       |       | $                                                                | (0.10      | )                                                           | $          | (0.28 | ) |

 

**6.         GOODWILL AND INTANGIBLEASSETS**

*Finite lived intangible assets*

Substantially allof the Company’s recorded intangible assets are subject to amortization. Finite lived intangible assets are comprised of the following: 
|                                      | ** ** | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **(in 000s)**          | ** ** |
| Amortizable  intangible assets:      |       |                        |       |                    |       |
| Patents and  gaming related products |       | $                           | 32,044     |                    | $          | 31,083 |   |
| Less:  accumulated amortization      |       | (7,219                      | )          | (5,202                  | )          |
|                                 |       | 24,825                      |       | 25,881                  |       |
|                                 |       |                        |       |                    |       |
| Licenses and  other                  |       | 31,290                      |       | 30,440                  |       |
| Less:  accumulated amortization      |       | (14,745                     | )          | (12,154                 | )          |
|                                 |       | 16,545                      |       | 18,286                  |       |
|                                 |       |                        |       |                    |       |
| Total                                |       | $                           | 41,370     |                    | $          | 44,167 |   |

 

*Indefinite lived intangible assets*

The carrying amount ofindefinite lived intangibles as of June 30, 2005 and December 31, 2005 was$5,284,000.

*Goodwill*

Changes in the carryingamount of goodwill for the six month period ended December 31, 2005, are asfollows:

|                                          | ** ** | **(in 000s)** | ** ** |
|------------------------------------------|------------|--------------------|------------|
| Balance at June 30,  2005                |       | $                  | 161,444    |   |
| Tax refund related  to an acquisition    |       | (346               | )          |
| Foreign currency  translation adjustment |       | (153               | )          |
| Balance at December 31, 2005             |       | $                  | 160,945    |   |

 

In March 2004, theCompany acquired Sierra Design Group (“SDG”). During the six month period ended December 31, 2005, the Company receiveda federal tax refund related to SDG’s pre-acquisition operations, which had notpreviously been recorded as an income tax receivable, and therefore, the cashreceived was recorded as an adjustment to goodwill.

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*Amortization of Intangibles*

Aggregate amortizationexpense totaled $2.6 million and $2.6 million, and $5.3 million and $4.6million for the three and six month periods ended December 31, 2005 and 2004,respectively.  Future amortization ofintangible assets is scheduled as follows:

|            | ** ** | **(in 000s)** | ** ** |
|------------|------------|--------------------|------------|
| 2006       |       | $                  | 4,652      |   |
| 2007       |       | 7,983              |       |
| 2008       |       | 5,762              |       |
| 2009       |       | 5,132              |       |
| 2010       |       | 4,753              |       |
| Thereafter |       | 13,088             |       |
| Total      |       | $                  | 41,370     |   |

 

**7.         LONG-TERM DEBT**

Long-term debtconsists of the following:
|                                          | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                               | ** ** | **2005**              | ** ** | **2005**          | ** ** |
| ** **                               | ** ** | **(in 000s)**    | ** ** |
| Term loan  facility                      |       | $                     | 313,132    |              | $          | 314,882 |   |
| Related party  debt (see Note 8)         |       | 18,237                |       | 19,206            |       |
| Other, generally  unsecured              |       | 713                   |       | 1,029             |       |
| Long-term debt                           |       | 332,082               |       | 335,117           |       |
| Less current  maturities                 |       | 9,250                 |       | 10,163            |       |
| Long-term debt,  less current maturities |       | $                     | 322,832    |              | $          | 324,954 |   |

 

The Company’s debtstructure at December 31, 2005 consists primarily of a term loan facility, a$75.0 million revolving credit facility, which is limited by a current leverageratio and debt owed to related parties. The term loan requires principalreductions of approximately 1% per annum paid quarterly, with a balloon paymentdue in September 2009.  The revolvingcredit facility commitment reduces annually until it comes due in September2008.  Based on the current leverageratio at December 31, 2005, the Company had approximately $15.4 million ofavailability under the revolving credit facility; however, there were noborrowings outstanding under the revolving credit facility.  As of December 31, 2005, the interest rate ineffect on the term loan was 10.75%, which was determined based on the interestrate formula of PRIME plus 1.75% plus a 2.00% default rate. On January 3, 2006and July 3, 2006, the Company initiated its next LIBOR-based term loan interestrate periods (for a term of six months) based on the interest rate formula ofLIBOR plus 3.50% and 3.75%, respectively, which was 8.18% and 9.33%,respectively.

The term loan andthe revolving credit facility are collateralized by substantially all of theCompany’s domestic property and are guaranteed by each of the Company’sdomestic subsidiaries, other than the entity that holds the Company’s interestin its Mississippi operations, and are secured by a pledge agreement. The loanagreement governing the term loan and the revolving credit facility (the “LoanAgreement”) contains a number of maintenance and other significant covenantsthat, among other things, restrict the ability of the Company and the abilityof certain of its subsidiaries to dispose of assets, incur additionalindebtedness and issue preferred stock, pay dividends or make otherdistributions, enter into certain acquisitions, repurchase equity interests orsubordinated indebtedness, issue or sell equity interests of the Company’ssubsidiaries, engage in mergers or acquisitions or certain transactions withsubsidiaries and affiliates, and that otherwise restrict corporateactivities.  The Company was incompliance with these covenants as of December 31, 2005.

As of December 31,2005, the Company was also in compliance with its financial covenantsconsisting of a leverage ratio, a fixed charges coverage ratio and a minimum ofEarnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) (asEBITDA is defined in the Loan Agreement). The leverage ratio is computed astotal average debt outstanding during the quarter divided by the trailing 12months EBITDA, excluding certain cash and non-cash charges. The Company’sleverage ratio as of December 31, 2005 was 4.3 times versus a maximum allowableof 4.5 times. The 

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maximum allowableleverage ratio declines to 4.25 as of March 31, 2006, 4.00 as of September 30,2006, 3.75 as of December 31, 2006 and 3.50 as of September 30, 2007, throughthe remaining term of the Loan Agreement.

In October 2006, the Company executed an amendment toits bank facility, which, among other things, (i) extended the due datefor the  delivery of the Company’s audited financialstatements for the fiscal year ended June 30, 2006 toDecember 31, 2006, (ii) provided that the Company shall deliver its quarterlyreports on Form 10-Q for the Fiscal Quarters ended September 30, 2005,December 31, 2005 and March 31, 2006 no later than December 31,2006, (iii) modified the definition of EBITDA to exclude up to $10 million ofcertain cash charges and (iv) clarified that the definitionof EBITDA includes interest income on trade receivables. The Company paid an administrative fee of $964,000, which will be expensed inthe quarter ended December 31, 2006, in exchange for the concessions grantedunder the amendment.

In December 2006,the Company executed an additional amendment to its bank facility, whichextended the due date for the  delivery of the Company’s quarterly reporton Form 10-Q for the Fiscal Quarter ended March 31, 2006 and its auditedfinancial statements for the fiscal year ended June 30,2006 to March 15, 2007. The Company paid an administrative fee of $1.2million, which will be expensed in the quarter ended December 31, 2006, inexchange for the concessions granted under the amendment.

The Company’srelated party debt, which totaled approximately $18.2 million as of December31, 2005, consists primarily of the debt owed to the former principals of SDG,Micro Clever Consulting (“MCC”) and MindPlay LLC (“MindPlay”).  See Note 8, Related Party Transactions, belowregarding related party debt.

**8.             RELATED PARTY TRANSACTIONS**

In the past twoyears, the Company completed the acquisition of all of the assets of MCC andSDG and substantially all of the assets and liabilities of MindPlay.  In each acquisition, a portion of theconsideration included subordinated debt issued to the former principals ofeach business.  Certain of the formerprincipals are now employees of the Company, and therefore, such debt isconsidered to be owed to related parties. The interest rates on the outstanding debt range from a variable rate ofLIBOR plus 2% to a fixed rate of 6%.  Seethe tables below for outstanding debt and interest rates as of December 31,2005 and June 30, 2005.
|                                              | ** ** | **As of  December 31, 2005** | ** ** | **As of  June 30, 2005** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **Interest  Rate**                          | ** ** | **Outstanding  Debt**                   | ** ** | **Interest  Rate** | ** ** | **Outstanding  Debt** | ** ** |
| ** **                                   | ** ** | **(in 000s)**                          | ** ** |
| SDG                                          |       | 4.42                                        | %          | $                                       | 14,000     |   | 4.42 | % | $ | 14,000 |   |
| MindPlay                                     |       | 6.00                                        | %          | 4,000                                   |       | 6.00 | % | 4,000 |   |
| MCC                                          |       | 6.84                                        | %          | 237                                     |       | 6.00 | % | 1,206 |   |
| Related party debt                           |       |                                        |       | 18,237                                  |       |   |   | 19,206 |   |
| Less current  maturities                     |       |                                        |       | 5,037                                   |       |   |   | 6,006 |   |
| Related party  debt, less current maturities |       |                                        |       | $                                       | 13,200     |   |   |   | $ | 13,200 |   |

 

In June 2005, theCompany issued approximately 1.0 million shares of its common stock inconnection with the conversion of $14.0 million of the subordinated debt andaccrued interest thereon owed to the former principals of SDG.  The remaining note payable to the formerprincipals of SDG of $14.0 million ispayable in annual installments through 2009. At the Company’s discretion, the principal and accrued interest thereoncan be paid in cash, or can be converted into shares of the Company’s commonstock using the average stock price for the 20 business days prior to thedelivery of such shares.

In February 2004, the Company acquired substantially all of the assetsand liabilities of MindPlay.  The initialpurchase price included, among other things, the issuance of a $4.0 millionnote payable.  As provided for in theacquisition agreement, the Company offset the entire amount due under thepromissory note in connection with an indemnification claim against the formershareholders of MindPlay related to the Company’s patent lawsuit with ShuffleMaster, Inc. 

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(“Shuffle Master”) and IGT which are described below in Note 13,Commitments and Contingencies.  Pursuantto the acquisition agreement, the Company is entitled to indemnification withrespect to 50% of all of the Company’s damages (including reasonable attorneys’fees) incurred in connection with the lawsuit, and is entitled to offset suchamount against any amounts due under the $4.0 million note payable. In March2006, the Company paid the selling shareholders of MindPlay $1.0 million underthe promissory note and the parties agreed to cancel the note.  The parties agreed to settle the remaining $3.0million obligation pending the outcome of the patent lawsuit.
|            | ** ** | **Total Interest Expense for the  Three Months Ended December 31,** | ** ** | **Total Interest Expense for the  Six Months Ended December 31,** | ** ** |
|------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|
| ** ** | ** ** | **2005**                                                                                                    | ** ** | **2004**                                                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** ** | ** ** | **(in 000s)**                                                                                          | ** ** |
| SDG        |       | $                                                                                                           | 160        |                                                                                                      | $          | — |   | $ | 319 |   | $ | — |   |
| MindPlay   |       | 72                                                                                                          |       | 98                                                                                                        |       | 143 |   | 159 |   |
| MCC        |       | 9                                                                                                           |       | 30                                                                                                        |       | 22 |   | 56 |   |
|            |            |                                                                                                             |            |                                                                                                           |            |  |  |  |  |  |  |  |  |

 

Accrued interest totaled $0.7 million and $0.3 million as of December31, 2005 and June 30, 2005, respectively.

Pursuant to an advisory agreement dated July 1, 2004 with KirklandInvestment Corporation, which is 100% owned by Joel Kirschbaum, a director ofthe Company, and therefore, treated as a related-party, the Company agreed topay Kirkland $600,000 annually for a period of 3.5 years for advisory andrelated services.  In August 2006, theCompany made its last payment under the advisory agreement as a result of Mr.Kirschbaum’s death.

The Company also leases a warehouse and office facility from an entityowned by Mr. Robert Luciano, a former principal of SDG and the Company’s ChiefTechnology Officer.  Rental paymentstotaled $103,000 and $206,000 and $137,000 and $240,000 for the three and sixmonth periods ended December 31, 2005 and 2004, respectively.

**9.             SEGMENTS AND GEOGRAPHICALINFORMATION**

The Companycurrently operates in two business segments (exclusive of the business segmentsincluded in discontinued operations): (i)Bally Gaming Equipment and Systems which designs, manufactures, distributes andoperates gaming machines and computerized monitoring systems for gamingmachines, and (ii) Casino Operations which currently owns and operates a casinoin Vicksburg, Mississippi. The accounting policies of these segments areconsistent with the Company’s policies for the unaudited condensed consolidatedfinancial statements.

The table belowpresents information as to the Company’s revenues and operating loss bysegment:
|                                | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31** | ** ** |
|--------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                            | ** ** | **2004**                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in 000s)**                                  | ** ** |
| Revenues:                      |       |                                                |       |                                             |       |   |   |   |   |
| Gaming Equipment and Systems   |       | $                                                   | 113,961    |                                             | $          | 111,666 |   | $ | 208,756 |   | $ | 218,471 |   |
| Casino Operations              |       | 14,492                                              |       | 12,769                                           |       | 26,047 |   | 25,605 |   |
| Total revenues                 |       | $                                                   | 128,453    |                                             | $          | 124,435 |   | $ | 234,803 |   | $ | 244,076 |   |
|                           |       |                                                |       |                                             |       |   |   |   |   |
| Inter-segment  revenues:       |       |                                                |       |                                             |       |   |   |   |   |
| Gaming Equipment and Systems   |       | $                                                   | 214        |                                             | $          | 84 |   | $ | 303 |   | $ | 256 |   |
| Casino Operations              |       | —                                              |       | —                                           |       | — |   | — |   |
| Total  inter-segment revenues  |       | $                                                   | 214        |                                             | $          | 84 |   | $ | 303 |   | $ | 256 |   |
|                           |       |                                                |       |                                             |       |   |   |   |   |
| Operating income  (loss):      |       |                                                |       |                                             |       |   |   |   |   |
| Gaming Equipment and Systems   |       | $                                                   | (4,817     | )                                                | $          | (1,694 | ) | $ | (6,245 | ) | $ | (983 | ) |
| Casino Operations              |       | 5,107                                               |       | 4,082                                            |       | 8,428 |   | 7,878 |   |
| Corporate/other                |       | (6,785                                              | )          | (4,740                                           | )          | (13,480 | ) | (10,490 | ) |
| Total operating income  (loss) |       | $                                                   | (6,495     | )                                                | $          | (2,352 | ) | $ | (11,297 | ) | $ | (3,595 | ) |

 

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The Company’soperations are based primarily in the United States with sales and distributionoffices in Europe and South America.

The table belowpresents information as to the Company’s revenues and operating loss bygeographic region:
|                                | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                            | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in 000s)**                                  | ** ** |
| Revenues:                      |       |                                                |       |                                              |       |   |   |   |   |
| United States                  |       | $                                                   | 120,172    |                                              | $          | 116,980 |   | $ | 221,277 |   | $ | 231,237 |   |
| Europe                         |       | 4,749                                               |       | 3,828                                             |       | 8,204 |   | 6,538 |   |
| Other foreign                  |       | 3,532                                               |       | 3,627                                             |       | 5,322 |   | 6,301 |   |
| Total revenues                 |       | $                                                   | 128,453    |                                              | $          | 124,435 |   | $ | 234,803 |   | $ | 244,076 |   |
|                           |       |                                                |       |                                              |       |   |   |   |   |
| Operating income  (loss):      |       |                                                |       |                                              |       |   |   |   |   |
| United States                  |       | $                                                   | (6,028     | )                                                 | $          | (664 | ) | $ | (10,383 | ) | $ | (1,065 | ) |
| Europe                         |       | (643                                                | )          | (2,264                                            | )          | (1,195 | ) | (3,602 | ) |
| Other foreign                  |       | 176                                                 |       | 576                                               |       | 281 |   | 1,072 |   |
| Total operating income  (loss) |       | $                                                   | (6,495     | )                                                 | $          | (2,352 | ) | $ | (11,297 | ) | $ | (3,595 | ) |

 

**10.****          RESTRUCTURINGCHARGE**

During the threemonth period ended September 30, 2004, the Company undertook a review of itsoperations and reduced its workforce. The reduction resulted in a restructuring charge and accrual totaling$1.4 million, of which $0.9 million was recorded at the Gaming Equipment andSystems segment and $0.5 million was recorded at the corporate level.  The balance of the accrued liability forunpaid severance costs is as follows:

|                                     | ** ** | **(in 000s)** | ** ** |
|-------------------------------------|------------|--------------------|------------|
| Beginning balance at  June 30, 2005 |       | $                  | 1,290      |   |
| Amounts paid                        |       | (744               | )          |
| Ending balance at December 31, 2005 |       | $                  | 546        |   |

 

**11.****          COMPREHENSIVELOSS**

The following is a reconciliation of the Company’s reported comprehensiveloss:
|                                   | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                            | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **(in 000s)**                                  | ** ** |
| Net loss                          |       | $                                                   | (8,903     | )                                                 | $          | (3,394 | ) | $ | (17,282 | ) | $ | (10,679 | ) |
| Currency  translation adjustments |       | (114                                                | )          | (162                                              | )          | (157 | ) | 6 |   |
| Comprehensive  loss               |       | $                                                   | (9,017     | )                                                 | $          | (3,556 | ) | $ | (17,439 | ) | $ | (10,673 | ) |

** **

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**12.****          SUPPLEMENTALCASH FLOW INFORMATION**

The following supplemental information is related to the condensedconsolidated statements of cash flows:
|                                                      | ** ** | **Six Month Ended  December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in 000s)**                               | ** ** |
| Cash paid for  interest                              |       | $                                                | 14,041     |   | $ | 7,218 |   |
| Cash paid for  income taxes                          |       | 2,289                                            |       | 3,057 |   |
|                                                 |       |                                             |       |   |   |
| Non-cash  investing and financing transactions:      |       |                                             |       |   |   |
| Transfer  property, plant and equipment to inventory |       | $                                                | 7,891      |   | $ | 3,423 |   |
| Foreign currency  translation                        |       | (134                                             | )          | 493 |   |

 

**13.****          COMMITMENTS ANDCONTINGENCIES**

OnSeptember 25, 1995, Bally Gaming Inc., a wholly-owned subsidiary of the Company(“BGI”), was named as a defendant in a class action lawsuit filed in the UnitedStates District Court for the District of Nevada. The plaintiffs filed suitagainst BGI and approximately 45 other defendants, each of which is involved inthe gaming business as a gaming machine manufacturer, distributor or casinooperator. The lawsuit arises out of alleged fraudulent marketing and operationof casino video poker machines and electronic slot machines. The plaintiffsalleged that the defendants have engaged in a course of fraudulent and misleadingconduct intended to induce people into playing their gaming machines based on afalse belief concerning how those machines actually operate, as well as theextent to which there is actually an opportunity to win on any given play. Theplaintiffs allege that the defendants’ actions constitute violations of theRacketeer Influenced and Corrupt Organizations Act (RICO) and give rise toclaims of common law fraud and unjust enrichment. The plaintiffs are seekingmonetary damages in excess of $1.0 billion. In July 2002, the federaldistrict court denied the plaintiffs’ request for class action certification.In August 2004, the United States Court of Appeals for the Ninth Circuitaffirmed the Federal District Court’s denial of class action certification, andthe plaintiffs did not appeal. Subsequently, two of the four named plaintiffselected to continue their cases as individual, non-class actions. However, inSeptember 2005, the court granted the defendants’ motions for summary judgment,resolving all claims in defendants’ favor without a trial. In October 2005, theplaintiffs appealed the District Court’s granting of summary judgment in favorof the defendants to the Ninth Circuit. Thereafter, the plaintiffs/appellantsagreed to dismiss their appeal in exchange for the defendants’ agreement not topursue a claim for costs.  The appeal wasdismissed on June 26, 2006.

In June and July2004, putative class actions were filed against Bally and its officers, RobertMiodunski, Robert Saxton, Mark Lerner and Steven Des Champs, in the UnitedStates District Court for the District of Nevada. The nearly identicalcomplaints alleged violations of the Securities Exchange Act of 1934, asamended, stemming from revised earnings guidance, declines in the stock price andsales of stock by insiders. The complaints sought damages in unspecifiedamounts. The Federal District Court granted the plaintiffs’ unopposed motionsto consolidate the cases and to appoint a lead counsel and a lead plaintiff,and the plaintiffs filed a consolidated complaint, all as is customary in suchcases. Bally and the other defendants have moved to dismiss the complaint.Thereafter, activity in the case was suspended and the parties participated ina mediation process.  The parties havereached an agreement in principle and are negotiating settlement documents,which will require court approval.

Inaddition, in July 2004, two derivative lawsuits were filed in Nevada statecourt against the members of the board of directors and the officers listed above.The Company was named as a nominal defendant in the derivative lawsuits as theclaims were purportedly asserted for the benefit of Bally. These lawsuitsasserted claims for breach of fiduciary duty and waste of corporate assetsarising out of the same events as those giving rise to the class actionsdescribed above, and sought injunctive relief and damages in unspecifiedamounts. These two cases were consolidated, and Bally and the other defendantsmoved to dismiss the case. In February 2005, the state district court grantedthe defendants’ motion and dismissed the case. The plaintiffs appealed thedismissal to the Nevada Supreme Court, which referred the matter to itssettlement conference program. The parties met with a court-appointed 

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settlementjudge on December 15, 2005, and agreed to settle the case for $8,000, and onFebruary 2, 2006, the Nevada Supreme Court entered its order formallydismissing the appeal, thereby terminating the case. Although managementbelieves the plaintiffs’ lawsuit and appeal were without merit, it determinedthat the settlement was in the best interests of the Company.

OnMarch 27, 2006, shortly after the aforementioned derivative suit was dismissedin the Nevada state court, another derivative lawsuit was filed in the UnitedStates District Court for the District of Nevada against individual defendantsRobert Miodunski, Robert Saxton, Steven Des Champs, Mark Lerner, David Robbins,Anthony DiCesare, Joel Kirschbaum, Kevin Verner, Richard Haddrill, StephenRace, Jacques André and nominal defendant Bally Technologies, Inc., in theUnited States District Court for the District of Nevada.  Based on allegations that are similar tothose alleged in the federal securities class action complaints and theprevious derivative actions that were dismissed by the District Court, thederivative complaint alleges breach of fiduciary duty, abuse of control, grossmismanagement, waste of corporate assets, unjust enrichment and violation ofthe Sarbanes-Oxley Act of 2002.  Theparties have reached an agreement in principle and are negotiating settlementdocuments.

During the sixmonths ended December 31, 2005, the Company accrued $1.3 million related to theanticipated settlement of the class action litigation and the March 27,2006 derivative suit.  The Company alsoaccrued approximately $0.5 million for legal fees related to the litigation inthe six months ended December 31, 2005, which totaled $1.9 million for thefiscal year ended June 30, 2006.

In August 2004,Shuffle Master, Inc. sued the Company in the United States District Court forthe District of Nevada, alleging infringement of various patents in connectionwith the Company’s MindPlay product line and seeking injunctive relief anddamages in an unspecified amount. In June 2005, it was announced that IGT hadacquired an interest in the patents at issue in the case, and thereafter IGTjoined the case as a plaintiff.  InDecember 2005, the Court issued a ruling construing the claim terms of allthe patents in the suit.  Management believes the plaintiffs’ lawsuit tobe without merit, and the Company is vigorously defending against the lawsuit.

InSeptember 2004, a United States District Court jury in the District of Nevadaentered a $7.4 million verdict against the Company in a suit filed by AGI andIGT. The suit alleged that the multi-hand video poker game deployed by theCompany’s former subsidiary, United Coin, infringed the plaintiffs’ patents.The Federal District Court ruled on summary judgment that the game does notinfringe the patents. However, the court left to the jury the question whetherthe use of “autohold,” a specific, optional feature of the game, caused it toinfringe under the “doctrine of equivalents,” a doctrine of patent law. After atwo-week trial, the jury determined that the game with the autohold optionenabled did infringe under the doctrine of equivalents and awarded damagesaccordingly. The feature has been disabled on all affected games in the field,and the decision permits continued deployment of the game as long as theautohold feature is not included. The Company appealed the decision to theUnited States Court of Appeals for the Ninth Circuit and has posted a cash bondtotaling $7.6 million to stay payment of the judgment and accrued interestpending the appeal. The cash bond is included in other non-current assets andthe accrued liability is included in accrued liabilities in the accompanyingbalance sheets. This amount has been accrued and the expense for this charge isincluded in discontinued operations in the accompanying statement of operationsfor 2004.  On July 11, 2006, the federalcircuit court of appeals affirmed the district court judgment, denying theappeals for both parties, and thereafter the judgment was satisfied out of theposted bond.

On December 7,2004, IGT filed a patent infringement lawsuit against Bally in the UnitedStates District Court for the District of Nevada. The complaint asserts thatBally’s wheel-based games, such as Monte Carlo, Lucky Wheel and Cash ForLife, its games with a reel in the top box, such as Bonus Frenzy, and its iViewproducts infringe on patents held by IGT, and seeks injunctive relief anddamages in unspecified amounts. Bally believes IGT’s claims are withoutmerit and is vigorously defending itself against the lawsuit. As part of itsdefense, Bally has asserted counterclaims against IGT, including claims thatIGT’s patents are invalid, unenforceable and not infringed, as well asseveral claims that IGT has engaged in anti-competitive conduct in violation ofstate and federal antitrust laws. By its counterclaims, Bally is seekingdamages and other relief from IGT. IGT’s motion to dismiss Bally’s antitrustclaims was denied on January 10, 2006. The litigation is in the discoveryphase and no trial date has been set.

InFebruary 2005, the SEC initiated an informal inquiry and requested documentsand information regarding matters related to the allegations in the classactions and similar matters. In August 2005, the SEC notified the Company that 

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itsinvestigation had entered a formal phase, and requested additional informationfrom the Company covering the same general areas that were addressed in theinformal inquiry. Management is cooperating fully with the SEC in this matter.

In May2006, IGT filed a patent infringement lawsuit against Bally in the UnitedStates District Court for the District of Delaware.  The complaint asserts that Bally’s PowerBonusing products infringe patents held by IGT, and seeks injunctive relief anddamages in unspecified amounts.  IGT’smotion for a preliminary injunction is pending. Bally believes IGT’s claims are without merit, including its request forpreliminary relief and is vigorously defending itself against the lawsuit.

InSeptember 2006, Bally filed a patent infringement lawsuit against IGT in theUnited States District Court for the District of Nevada.  The complaint asserts that certain of IGT’sbonus wheel games infringe patents held by Bally, and seeks injunctive reliefand damages.  IGT filed an answergenerally denying the claims.  The caseis in the discovery phase and no trial date has been set.

The Company isalso a party to various lawsuits relating to routine matters incidental to itsbusiness.  Except as described above,management does not believe the outcome of such litigation, individually or inthe aggregate,  will have a materialadverse effect on the Company’s financial position or results of operations.

**14.****          SUBSEQUENT EVENTS**

During the fiscalquarter ended March 31, 2006, the Company determined certain of its leasedgaming equipment was no longer deployable as a result of a shifting marketdemand towards newer Bally products that incorporate more innovativefeatures.  As a result, the Companycommitted to a plan to abandon certain of these assets.  The Company expects to record a charge of$1.0 million in the quarter ended March 31, 2006 relating to the abandonment.

In accordance withthe Company’s accounting policy, during the fiscal quarter ended June 30, 2006,the Company evaluated the carrying value of goodwill and other intangibleassets and determined that certain intangible assets were impaired.  As a result, the Company expects to record animpairment charge of approximately $5.5 to $6.5 million in the fourthquarter of fiscal year 2006.

Additionally,during the fiscal quarter ended June 30, 2006, the Company evaluated thecarrying value of its prepaid royalties, which are classified as other assets,and determined that certain amounts were not recoverable based on expectedsales of the related products.  As aresult, the Company expects to record a charge of approximately $2.5 to $3.5 millionin the fourth quarter of fiscal year 2006.

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** **

**ITEM 2.****                          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

We begin Management’s Discussion and Analysis of Financial Condition andResults of Operations with a brief description of the restatement, as well asan overview of our key operating business divisions and significanttrends.  This overview is followed by adetailed analysis of our results of operations and our financial condition asof, and for, the three and six month periods ended December 31, 2005.

**Forward-LookingStatements**

Certain matters in this Quarterly Report on Form 10-Q for the three andsix month periods ended December 31, 2005 and our other filings with the SEC,including, without limitation, certain matters discussed in this Management’sDiscussion and Analysis of Financial Condition and Results of Operations and inQuantitative and Qualitative Disclosures about Market Risk, constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended,and are subject to the safe harbor created thereby.  Those statementsreflect the intent, belief or current expectations of the Company, itsdirectors or its officers with respect to, among other things, future eventsand financial trends affecting the Company.

Forward-lookingstatements are typically identified by the words “believes,” “expects,” “anticipates”and similar expressions.  In addition,any statements that refer to expectations or other characterizations of futureevents or circumstances are forward-looking statements.  Readers are cautioned that any suchforward-looking statements are not guarantees of future performance and thatmatters referred to in such forward-looking statements involve known andunknown risks, uncertainties and other factors which may cause actual results,performance or achievements of the Company to be materially different from anyfuture results, performance or achievements expressed or implied by suchforward-looking statements.  Such factorsinclude, among other things, the impact of competition and uncertaintiesconcerning such matters as the Company’s ability to service debt, productdevelopment, customer financing, sales to non-traditional gaming markets,foreign operations, dependence on key personnel, the ability to integratefuture acquisitions, strict regulation by gaming authorities, the outcome ofpending litigation matters including the pending securities class actions,gaming taxes, currency fluctuations and market risk and the potential adverseeffects to our financial condition, results of operations or prospects as aresult of the restatement of our prior period financial statements. Certain ofthese factors are discussed in the “Risk Factors” contained in the 200510-K.  The Company undertakes no obligationto publicly update or revise these forward-looking statements because of newinformation, future events or otherwise.

**Restatement**

The condensed consolidated statements of operationsand cash flows for the three and six month periods ended December 31, 2004,have been restated. The restatement related primarily to revenue recognition,accounting for inventory costs and other miscellaneous adjustments that werethe result of certain accounting errors, as more fully discussed in Note 2 tothe unaudited condensed consolidated financial statements.  The financial information set forth in thefollowing Management’s Discussion and Analysis gives effect to the restatement.

**Our Business**

We are a worldwide leaderin designing, manufacturing, distributing and operating gaming machines andcomputerized monitoring systems for gaming facilities.  We also own and operate the Rainbow Casino, adockside casino in Vicksburg, Mississippi.

Wederive our revenues from the following four divisions:

*Gaming Equipment - *Sale of gamingmachines;

*Gaming Operations -*Operationof wide-area progressive systems and lease of gaming machines;

*Systems -*Salesof computerized monitoring systems and related recurring hardware and softwaremaintenance

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revenue; and

*Casino Operations -*Operationof the Rainbow Casino.

We design, manufacture and sell a variety of electronicslot and video gaming machines through our Gaming Equipment division and havemarketed over 100,000 machines during the past five years.  Each gaming machine contains an operatingsystem, also referred to as a game platform. The machine’s operating system manages the software needed to run themachine.  In the fiscal year endedJune 30, 2005, we successfully completed our migration from the EVOTM platformto the Linux based ALPHA OSTM platform. ALPHA OS distinguishes itself from other industry platforms as anoperating system designed for complete separation between the underlyingoperating system and the game applications, providing enhanced efficiency ingame development and speed to market. ALPHA OS also incorporates free spin,scatter, bonusing and other advanced game features, while the related gameinterface provides internal and third-party developers with a secure,easy-to-use programming environment that incorporates an advanced set ofdevelopment tools.   Moreover, ALPHA OSwas designed to support server-based gaming initiatives, including download ofgame results, configuration and game content.

Our GamingOperations division offers three general types of games that are placed incasinos or other permissible gaming locations. The three general types of games are those that are linked on aproprietary wide-area progressive system, those that operate on a proprietarynear-area progressive system and those that are non-linked niche games.  These gaming machines earn recurring revenuesand cash flows for us rather than being sold on a one-time basis.

We believe thegrowth of the Gaming Equipment and Gaming Operations divisions is dependent onproviding new titles and technologies with high entertainment value to casinopatrons.  We spent approximately 9% ofour revenue for the six months ended December 31, 2005 on research anddevelopment to accelerate the use of technology in our gaming products.

We also design and sell casino enterprise systems under ourSystems division.  Our primary casinoenterprise systems products are designed to streamline casino businessprocesses through the use of technology and include slot monitoring, casinomanagement and cashless systems.  Wemarket our casino enterprise system product solutions under the broadcategories of Bally CMS® (Casino Management Systems), Bally SMS® (SlotManagement Systems) and Bally TMS® (Table Management Systems).

Competition in our Systems division continues tointensify.  Our goal is to maintain afirst or second position in each of our software product categories and to growour software revenues faster than our competitors.  We have also continued to focus on improvingthe overall quality of our software products and services levels.  In addition, substantially all our customersrenew their software licenses updates and product support contracts annually,thereby eliminating the need to repurchase new software licenses when newupgrades are released.

Our Rainbow Casinois one of four casinos currently operating in the Vicksburg, Mississippi marketand is run through our Casino Operations division. The casino, which hasapproximately 12 table games and approximately 905 gaming devices, drawscustomers primarily from a 75-mile radius surrounding Vicksburg, which includesJackson, Mississippi.  While a number ofproperties located on the gulf coast sustained heavy damage during the 2005hurricane season, our casino did not sustain any significant damage.  Although it was temporarily closed followingHurricane Katrina, we reopened the property for business within four days ofthe storm, once power was restored to the general area.  The play levels at our casino have generally increasedfollowing the reopening.  The Companyannounced in October 2006 that it is evaluating alternatives with respect tothe possible sale of the Rainbow Casino. There can be no assurance that the Company will complete the sale of theRainbow Casino.

**Resultsof Operations**

Our results of operations include the accounts of Bally Technologies,Inc., and its wholly-owned and partially-owned subsidiaries.  We report our revenue and income intwo segments, the Bally Gaming Equipment and Systems segment, which includesour Gaming Equipment, Systems and Gaming Operations divisions, and our CasinoOperations segment.  Revenue from ourBally Gaming and Systems segment represents approximately 89% of our totalrevenues.  The table below sets forth our consolidatedresults of operations for the three months and six month periods ended December31, 2005 and 2004.

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| ** **                         | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                | ** ** | **%  Rev**                                            | ** ** | **2004** | ** ** | **%  Rev** | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** | **%  Rev** | ** ** | **2004** | ** ** | **%  Rev** | ** ** | **Increase/  (Decrease)** | ** ** |
| ** **                         | ** ** | **(dollars in millions)**                     | ** ** |
| Revenues                           |       | $                                                       | 128.4      |                                                  | 100        | % | $ | 124.5 |   | 100 | % | 3 | % | $ | 234.8 |   | 100 | % | $ | 244.1 |   | 100 | % | (4 | )% |
| Gross profit                       |       | $                                                       | 58.3       |                                                  | 45         | % | $ | 53.8 |   | 43 | % | 8 | % | $ | 111.4 |   | 47 | % | $ | 113.8 |   | 47 | % | (2 | )% |
| Operating loss                     |       | $                                                       | (6.5       | )                                                     | (5         | )% | $ | (2.4 | ) | (2 | )% | 171 | % | $ | (11.3 | ) | (5 | )% | $ | (3.6 | ) | (1 | )% | 214 | % |
| Loss from continuing  operations   |       | $                                                       | (8.9       | )                                                     | (7         | )% | $ | (3.4 | ) | (3 | )% | 162 | % | $ | (17.3 | ) | (7 | )% | $ | (6.3 | ) | (3 | )% | 175 | % |
| Loss from discontinued  operations |       | $                                                       | —     |                                                  | —     | % | $ | — |   | — | % | — | % | $ | — |   | — | % | $ | (4.4 | ) | (2 | )% | (100 | )% |
| Net loss                           |       | $                                                       | (8.9       | )                                                     | (7         | )% | $ | (3.4 | ) | (3 | )% | 162 | % | $ | (17.3 | ) | (7 | )% | $ | (10.7 | ) | (4 | )% | 62 | % |

 

***Bally Gaming Equipment and Systems***

The summary financial results and operatingstatistics for our Bally Gaming Equipment and Systems segment for the threemonth and six month periods ended December 31, 2005 and 2004 are as follows: 
| ** **                           | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                                | ** ** | **%  Rev**                                            | ** ** | **2004** | ** ** | **%  Rev** | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** | **%  Rev** | ** ** | **2004** | ** ** | **%  Rev** | ** ** | **Increase/  (Decrease)** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                     | ** ** |
| Revenues                             |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gaming Equipment                     |       | $                                                       | 54.1       |                                                  | 47         | % | $ | 55.8 |   | 50 | % | (3 | )% | $ | 91.4 |   | 44 | % | $ | 106.3 |   | 49 | % | (14 | )% |
| Systems                              |       | 25.0                                                    |       | 22                                                    | %          | 25.5 |   | 23 | % | (2 | )% | 45.6 |   | 22 | % | 48.8 |   | 22 | % | (7 | )% |
| Gaming Operations                    |       | 34.9                                                    |       | 31                                                    | %          | 30.4 |   | 27 | % | 15 | % | 71.8 |   | 34 | % | 63.4 |   | 29 | % | 13 | % |
| Total revenues                       |       | $                                                       | 114.0      |                                                  | 100        | % | $ | 111.7 |   | 100 | % | 2 | % | $ | 208.8 |   | 100 | % | $ | 218.5 |   | 100 | % | (4 | )% |
|                                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross margin                         |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gaming Equipment                     |       | $                                                       | 15.5       |                                                  | 29         | % | $ | 8.5 |   | 15 | % | 82 | % | $ | 24.7 |   | 27 | % | $ | 24.0 |   | 23 | % | 3 | % |
| Systems                              |       | 19.6                                                    |       | 78                                                    | %          | 19.7 |   | 77 | % | (1 | )% | 37.3 |   | 82 | % | 38.5 |   | 79 | % | (3 | )% |
| Gaming Operations                    |       | 13.6                                                    |       | 39                                                    | %          | 17.4 |   | 57 | % | (22 | )% | 32.6 |   | 45 | % | 35.1 |   | 55 | % | (7 | )% |
| Total gross margin                   |       | $                                                       | 48.7       |                                                  | 43         | % | $ | 45.6 |   | 41 | % | 7 | % | $ | 94.6 |   | 45 | % | $ | 97.6 |   | 45 | % | (3 | )% |
|                                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative |       | $                                                       | 37.1       |                                                  | 33         | % | $ | 33.1 |   | 30 | % | 12 | % | $ | 69.5 |   | 33 | % | $ | 68.4 |   | 31 | % | 2 | % |
| Research and development  costs      |       | 10.7                                                    |       | 9                                                     | %          | 10.3 |   | 9 | % | 4 | % | 21.0 |   | 10 | % | 22.1 |   | 10 | % | (5 | )% |
| Restructuring charges                |       | —                                                  |       | —                                                | %          | — |   | — | % | — | % | — |   | — | % | 0.9 |   | — | % | (100 | )% |
| Depreciation and  amortization       |       | 5.7                                                     |       | 5                                                     | %          | 3.9 |   | 3 | % | 46 | % | 10.3 |   | 5 | % | 7.2 |   | 3 | % | 43 | % |
| Operating income (loss)              |       | $                                                       | (4.8       | )                                                     | (4         | )% | $ | (1.7 | ) | (2 | )% | 182 | % | $ | (6.2 | ) | (3 | )% | $ | (1.0 | ) | — | % | 520 | % |

 
|                                          | ** **   | **Three Months Ended December 31,** | ** **   | **Six Months Ended December 31,** | ** **   |
|------------------------------------------|--------------|---------------------------------------------------------|--------------|-------------------------------------------------------|--------------|
| ** **                               | ** **   | **2005**                                                | ** **   | **2004**                                              | ** **   | **Increase/  (Decrease)** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase/  (Decrease)** | ** ** |
| Operating  Statistics:                   | *** *** | *** ***                                            | *** *** | *** ***                                          | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| New gaming devices sold                  |         | 3,663                                                   |         | 2,677                                                 |         | 37 | % | 6,463 |   | 6,734 |   | (4 | )% |
| OEM units sold                           |         | 305                                                     |         | 2,657                                                 |         | (89 | )% | 326 |   | 2,907 |   | (89 | )% |
| New unit average selling price           |         | $                                                       | 10,921       |                                                  | $            | 10,290 |   | 6 | % | $ | 10,802 |   | $ | 10,425 |   | 4 | % |
|                                     |         |                                                    |         |                                                  |         |   |   |   |   |   |   |   |   |
| Gaming monitoring units installed base   |         | 266,000                                                 |         | 280,000                                               |         | (5 | )% | 266,000 |   | 280,000 |   | (5 | )% |
| Casino management systems installed base |         | 532                                                     |         | 220                                                   |         | 142 | % | 532 |   | 220 |   | 142 | % |
| Systems managed cashless games           |         | 161,000                                                 |         | 109,000                                               |         | 48 | % | 161,000 |   | 109,000 |   | 48 | % |
|                                     |         |                                                    |         |                                                  |         |   |   |   |   |   |   |   |   |
| End of period installed base:            |         |                                                    |         |                                                  |         |   |   |   |   |   |   |   |   |
| Wide-area progressive                    |         | 1,305                                                   |         | 1,746                                                 |         | (25 | )% | 1,305 |   | 1,746 |   | (25 | )% |
| Daily-fee games                          |         | 10,107                                                  |         | 8,768                                                 |         | 15 | % | 10,107 |   | 8,768 |   | 15 | % |
| Centrally  determined games              |         | 23,631                                                  |         | 17,725                                                |         | 33 | % | 23,631 |   | 17,725 |   | 33 | % |
|                                          |              |                                                         |              |                                                       |              |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ThreeMonths Ended December 31, 2005 Compared to Three Months Ended December 31, 2004**

Total revenues forour Bally Gaming Equipment and Systems segment increased $2.3 million, or 2%,for the three months ended December 31, 2005 as compared to the correspondingperiod in the prior year.  This increase wasprimarily the result of an increase in revenues from our Gaming Operationsdivision of approximately 15%, which was offset by both a decrease in GamingEquipment division revenue of approximately 3% and a decrease in Systemsdivision revenue of 2%.  A more detaileddescription of the fluctuations in revenues of each Bally Gaming Equipment andSystems division set forth below.

Selling, generaland administrative expenses for the segment increased by $4.0 million for thethree months ended December 31, 2005 as compared to the corresponding period inthe prior year.  This increase wasprimarily attributed to an increase in payroll and related expenses of $3.9million, $1.6 million of which was associated with share-based compensationexpenses charged to this segment as a result of the adoption of SFAS No. 123R,as more fully discussed in Note 5 to the condensed consolidated financialstatements*.* Salaries and wages increased by 8% andcontributed approximately to $1.3 million to the additional payroll and relatedexpenses due to an increase in the number or employees.  Legal fees increased by $0.9 million inconnection with SEC reporting matters primarily related to the restatement ofpreviously issued financial statements. These amounts were partially offset by a decrease in marketing expensesof $1.3 million related to the timing of certain trade show events.

Research anddevelopment costs for the segment increased by $0.4 million, or 4%, for thethree months ended December 31 2005, as compared to the corresponding period inthe prior year.  This increase was theresult of an 11% increase in the number of employees for the three month periodended December 31, 2005, as compared to the corresponding period in the prioryear.

Depreciation andamortization expense increased by $1.8 million, or 46%, for the three monthsended December 31, 2005, as compared to the corresponding period in the prioryear, primarily due to a change in the estimated useful life and salvage valuesfor certain assets classified as leased gaming equipment.  This change in estimate resulted in a $1.0million increase in depreciation expense for the three months ended December31, 2005.  The remaining increase in depreciationexpense was a result of higher capital expenditures incurred during the priortwelve month period.

*GamingEquipment.*  Revenuesfrom our Gaming Equipment division decreased by $1.7 million, or 3%, for thethree months ended December 31, 2005, as compared to the corresponding periodin the prior year.  This was primarily aresult of the decrease in overall sales to original equipment manufacturers (“OEMs”)from 2,657 units for the three months ended December 31, 2004 to 305 units inthe current quarter. Sales of OEM products vary significantly from period toperiod and are based on deployments by our OEM customers. The decrease in OEMunits sold was partially offset by an increase of 986 new gaming units sold inthe current quarter.  Additionally, theaverage selling price of new gaming units increased $631, or 6%, which reflectedhigher sales of games built on the ALPHA OS platform, which generally has ahigher per unit price than our legacy products.

Gross marginimproved from 15% in the prior year quarter to 29% in the quarter endedDecember 31, 2005. This increase was primarily due to a reduction in inventoryimpairment charges of $7.0 million from $11.1 million at December 31, 2004 to$4.1 million at December 31, 2005. Additionally, gross margin was higher as a result of an increase in theaverage selling price of new gaming units sold.

*Systems.*  Revenues from our Systems division decreasedby $0.5 million, or 2%, for the three months ended December 31, 2005, ascompared to the corresponding period in the prior year.  This decrease was primarily due to areduction in revenue recognized from extended payment terms of $1.9 million asa result of the early payoff of an extended payment term contract during thethree month period ended December 31, 2004 and a $4.2 million decrease inhardware sales due to the timing of certain system installations.  No such early payoff occurred in the currentperiod.  This decrease was offset byhigher sales attributable to international markets, totaling $1.5 million,coupled with an increase in CMP software and service revenues of $1.3 million.

Grossmargin from the Systems division remained relatively consistent at 78% for thethree months ended December 31, 2005, as compared to 77% for the three monthsended December 31, 2004.

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*GamingOperations. *Revenuesfrom the Gaming Operation division increased by $4.5 million, or 15%, for thethree months ended December 31, 2005, as compared to the corresponding periodin the prior year.  The increase inrevenue was primarily a result of the following factors:

·                  A $5.5 million,or 51%, increase in revenues derived from centrally determined games as theresult of additional installations of our Class II units;

·                  A $0.3 millionincrease in revenues derived from the consolidation of variable interestentities; and

·                  A$0.1 million increase in revenues as a result of the increased base of dailyfee games.

Theseincreases were partially offset by a reduction in wide area progressiverevenues of $1.2 million resulting from a 12% decrease in the installed base ofgames during the period.

Gross margin,which includes depreciation and amortization expense of $11.4 million and $6.9million for the three months ended December 31, 2005 and 2004,  declined to 39% for the three months endedDecember 31, 2005, from 57% in the corresponding period in 2004.  This was primarily a result of a change inthe estimated useful life and salvage values for certain gaming equipment usedin the Gaming Operations division. During the three months ended December 31, 2005, this reassessmentresulted in a $5.8 million increase in depreciation expense charged to cost ofgaming equipment and systems.

**SixMonths Ended December 31, 2005 Compared to Six Months Ended December 31, 2004**

Total revenues forour Bally Gaming Equipment and Systems segment decreased $9.7 million, or 4%,for the six months ended December 31, 2005, as compared to the correspondingperiod in the prior year.  This decreasewas primarily the result of a decrease in revenues from our Gaming Equipmentand Systems divisions of approximately 14% and 7%, respectively.  These decreases were offset by higher GamingOperations division revenues of $8.4 million, or 13%.  A more detailed description of thefluctuations in revenues of each of Bally Gaming and Systems division is setforth below.

Selling, generaland administrative expenses for the segment increased by $1.1 million, or 2%,for the six months ended December 31 2005, as compared to the correspondingperiod for in the prior year, which included $0.9 million of restructuringcharges.  This increase was primarilyattributed to an increase in payroll and related expenses of $3.1 million, allof which was associated with share based compensation expenses charged to thissegment as a result of the adoption of SFAS No. 123R, as more fully discussedin Note 5 to the condensed consolidated financial statements.

Research anddevelopment costs for the segment decreased by $1.1 million, or 5%, for the sixmonths ended December 31 2005, as compared to the corresponding period in theprior year.  This decrease was a resultof the elimination of certain costs tied to the completion and successfuldeployment of the ALPHA OS products and related game content as well as areduction in spending on our legacy products. This decrease was partially offset by an increase in the number ofemployees during the latter half of the current period.

Depreciation andamortization expense increased by $3.1 million, or 43%, for the six monthsended December 31, 2005, as compared to the corresponding period of in theprior year primarily due to a change in the estimated useful life and salvagevalues for certain assets classified as leased gaming equipment. This change inestimate resulted in a $1.0 million increase in depreciation expense for thesix months ended December 31, 2005.  Theremaining increase in depreciation expense was a result of higher capitalexpenditures incurred during the prior twelve month period.

*GamingEquipment.* Revenuesfrom our Gaming Equipment division decreased by $14.9 million, or 14%, for thesix months ended December 31, 2005, as compared to the corresponding period inthe prior year.  This was primarily aresult of an 89% decrease in sales to OEMs from 2,907 units for the six monthsended December 31, 2004 compared to 326 units in the current year period. Salesof such OEM products vary significantly from period to period and are based ondeployments by our OEM customers. A decrease in new gaming units sold of 271units, from 6,734 units in the six months ended December 31, 2004 to 6,463units in the corresponding period of the current year, also contributed tooverall decrease in revenues.  Thisdecrease was partially offset by an increase in the average selling

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price of newgaming units to $377 which reflected higher sales of games built on the ALPHAOS platform, which generally has a higher per unit price than our legacyproducts.

Gross marginimproved from 23% in the prior six month period to 27% for the six months endedDecember 31, 2005. This increase was primarily due to a reduction in inventoryimpairment charges of $8.0 million for the six months ended December 31, 2005,compared to $14.6 million for the corresponding period in the prior year.

*Systems.*  Revenues from our Systems division decreasedby $3.2 million, or 7%, for the six months ended December 31, 2005, as comparedto the corresponding period in the prior year. This decrease was primarily due to a reduction in revenue recognizedfrom extended payment terms of $2.3 million as a result of the early payoff ofan extended payment term contract during the six months ended December 31, 2004and a $4.4 million decrease in hardware sales due to the timing of certainsystem installations.  No such payoffoccurred in the current period.   Thisdecrease was partially offset by a $3.3 million increase in both CMP softwareand international sales of our systems products.

Grossmargin from our Systems division improved to 82% for the six months endedDecember 31, 2005 from 79% in the corresponding prior period.  This increase was primarily due to theincrease in software sales and maintenance revenue that produce higher marginsas compared to other components such as hardware sales.

*GamingOperations.*Revenues from our Gaming Operation divisionincreased by $8.4 million, or 13%, for the six months ended December 31, 2005,as compared to the corresponding period in the prior year.  The increase in revenue was primarily aresult of the following factors:

·                  A $7.7 million,or 34%, increase in revenues derived from centrally determined games as theresult of additional installations of our Class II machines; and

·                  A$2.9 million increase in revenues derived from the consolidation of variableinterest entities.

Theseincreases were offset by a decrease in wide area progressive revenue of $2.1million as a result of the decrease in the installed base of games during theperiod.

Gross margin,which includes depreciation and amortization expense of $18.1 million and $13.3million for the six months ended December 31, 2005 and 2004, declined to 45%for the six months ended December 31, 2005, from 55% in corresponding period inthe prior year.  This was primarily a resultof a change in the estimated useful life and salvage values for certain gamingequipment used in the Gaming Operations division.  During the six months ended December 31,2005, this reassessment resulted in a $5.8 million increase in depreciationexpense charged to cost of gaming equipment and systems.

***Casino Operations***

OurRainbow Casino is one of four casinos currently operating in the Vicksburg,Mississippi market. The casino draws customers primarily from a 75-mile radiussurrounding Vicksburg, which includes Jackson, Mississippi.  While a number of properties located on theGulf Coast sustained heavy damage during the 2005 hurricane season, our casinodid not sustain any significant damage. Although it was temporarily closed, we reopened the property forbusiness within four days of Hurricane Katrina, once power was restored to thegeneral area.  While the play levels atour casino increased somewhat during the months following the reopening, theplay levels returned to a more typical level once some of the other Gulf Coastcasinos reopened.

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The summary of ourfinancial results and operating statistics for our Casino Operation are asfollows:

|                                      | ** ** | **Three Months Ended December 31,** | ** **   | **Six Months Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|--------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                                | ** **   | **2004**                                              | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase/  (Decrease)** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                     | *** *** |
| Revenue                              |       | $                                                       | 14.4         |                                                  | $          | 12.8 |   | 13 | % | $ | 26.0 |   | $ | 25.6 |   | 2 | % |
|                                 |       |                                                    |         |                                                  |       |   |   |   |   |   |   |   |   |
| Gross margin                         | ** ** | $                                                       | 9.5          |                                                  | $          | 8.2 |   | 16 | % | $ | 16.8 |   | $ | 16.2 |   | 4 | % |
| Selling, general  and administrative | ** ** | $                                                       | 3.5          |                                                  | $          | 3.3 |   | 6 | % | $ | 6.6 |   | $ | 6.7 |   | (1 | )% |
| Depreciation and  amortization       | ** ** | $                                                       | 0.9          |                                                  | $          | 0.8 |   | 13 | % | $ | 1.8 |   | $ | 1.6 |   | 13 | % |
| Operating income                     | ** ** | $                                                       | 5.1          |                                                  | $          | 4.1 |   | 24 | % | $ | 8.4 |   | $ | 7.9 |   | 6 | % |
|                                 |       |                                                    |         |                                                  |       |   |   |   |   |   |   |   |   |
| Operating  statistics:               |       |                                                    |         |                                                  |       |   |   |   |   |   |   |   |   |
| Average number  of gaming devices    | ** ** | 905                                                     |         | 930                                                   |       | (3 | )% | 921 |   | 930 |   | (1 | )% |
| Average number of table  games       | ** ** | 12                                                      |         | 12                                                    |       | — | % | 12 |   | 12 |   | — | % |

 

**Three andSix Months Ended December 31, 2005 Compared to Three and Six Months EndedDecember 31, 2004**

Casino Operationsrevenue improved 13% and 2% for the three and six month periods ended December31, 2005, respectively, as compared to the corresponding periods in the prioryear.  The increases were attributable tothe fact that, unlike in respect of our competitors’ properties, our propertydid not sustain any significant damage in connection with the Gulf Coasthurricanes in August and September 2005.

Overall gross margins,selling, general and administrative expenses as a percentage of revenueimproved for both the three and six month periods ended December 31, 2005, as aresult of costs remaining fairly stable while revenue improved, as mentionedabove. Depreciation and amortization expense increased slightly to $0.9 millionand $1.8 million, respectively, as a result of additions and renovations duringthe fiscal year ended June 30, 2005.

***Parent Company***

The summaryfinancial results of Bally Technologies, Inc., our parent entity, are set forthbelow.  These results also includecertain other income and expenses that are otherwise not allocated to aspecific business segment.

|                                      | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                                | ** ** | **2004**                                              | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase/  (Decrease)** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                     | ** ** |
| Selling, general  and administrative |       | $                                                       | 6.5        |                                                  | $          | 4.3 |   | 51 | % | $ | 12.8 |   | $ | 9.8 |   | 31 | % |
| Depreciation and  amortization       |       | 0.3                                                     |       | 0.4                                                   |       | (25 | )% | 0.7 |   | 0.7 |   | — | % |
| Total Parent  Company expense        |       | $                                                       | 6.8        |                                                  | $          | 4.7 |   | 45 | % | $ | 13.5 |   | $ | 10.5 |   | 29 | % |
|                                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Operating income  (expense)          |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Interest income                      |       | $                                                       | 0.6        |                                                  | $          | 1.1 |   | (45 | )% | $ | 1.5 |   | $ | 1.9 |   | (21 | )% |
| Interest expense                     |       | (7.3                                                    | )          | (3.8                                                  | )          | 92 | % | (13.2 | ) | (7.8 | ) | 69 | % |
| Loss on extinguishment of debt       |       | —                                                  |       | (0.6                                                  | )          | (100 | )% | — |   | (0.6 | ) | (100 | )% |
| Other, net                           |       | (0.2                                                    | )          | 0.5                                                   |       | (140 | )% | (0.5 | ) | 0.8 |   | (163 | )% |
| Total other  income (expense)        |       | $                                                       | (6.9       | )                                                     | $          | (2.8 | ) | 146 | % | $ | (12.2 | ) | $ | (5.7 | ) | 114 | % |
|                                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income tax  benefit                  |       | $                                                       | 4.7        |                                                  | $          | 2.9 |   | 62 | % | $ | 8.8 |   | $ | 4.6 |   | 91 | % |
| Minority interest                    |       | $                                                       | (0.2       | )                                                     | $          | (1.1 | ) | 82 | % | $ | (2.6 | ) | $ | (1.6 | ) | (63 | )% |

 

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**ThreeMonth and Six Months Ended December 31, 2005 Compared to Three Month and SixMonths Ended December 31, 2004**

Our selling,general and administrative expenses at the parent company level increased $2.2million and $3.0 million, respectively, for the three and six month periodsended December 31, 2005, as compared to the corresponding periods in the prioryear.  These increases were a result ofthe following:

·                  The accrual of$1.8 million in fiscal 2005 related to the anticipated settlement of classaction litigation;

·                  An increase inprofessional fees of $1.4 million and $2.4 million, respectively, primarilyattributable to the restatement of previously issued financial statements; and

·                  Share-basedcompensation expense charged to this segment of $1.0 million and $2.2 million,respectively, as a result of the adoption of SFAS No. 123R.

These increaseswere partially offset by the following:

·                  Adecrease in salary and wages of $0.1 million and $1.4 million, respectively,due to the reclassification of certain employees to our Bally Gaming Equipmentand Systems segment as well as a reduction in costs related to the prior yearrestructuring.

Minorityinterest  increased, primarily as aresult of the consolidation of certain variable interest entities. Finally,interest expense for the three and six month periods ended December 31, 2005totaled $7.3 million and $13.2 million, respectively, compared to $3.8 millionand $7.8 million in the prior year periods. The increase in interest expense was a result of higher interest ratesin effect in the current periods as well as a charge of $0.7 million in defaultinterest (see Note 7 Long-Term Debt, of the Notes to Condensed ConsolidatedFinancial Statements).

The effectiveincome tax rate for the six month period ended December 31, 2005 was 34% ascompared to 42% for the corresponding period in 2004.  The effective tax rate for the six monthsended December 31, 2005 was affected by our adoption of SFAS No. 123R and theresulting non-deductible share-based compensation expense recognized for bookpurposes, the expiration of the research and development tax credits on ourfederal tax return for the last half of fiscal year 2006 and reserves appliedto certain deferred tax assets from foreign losses.

***SignificantItems Affecting Comparability***

Certain significant items affect the comparability of financialstatements from the three month and six month periods ended December 31, 2005,to the corresponding periods in the previous fiscal year.  These items are discussed below.

*Inventoryand asset write-downs. *We perform detailedinventory valuation procedures at least quarterly.  This process includes examining the carryingvalues of new and used gaming devices, parts and ancillary equipment incomparison to the current fair market values for such equipment (less costs tosell or dispose).  Some of the factorsinvolved in this analysis include the overall levels of our inventories, thecurrent and projected sales levels for such products, the projected markets forsuch products both domestically and internationally, the costs required to sellthe products including refurbishment costs and importation costs forinternational shipments, and the overall projected demand for products.

During fiscal year2005 we faced declining demand for gaming devices based on our legacy platform,and therefore, we continually assessed this particular portion of ourinventory.  In October 2004, we made thestrategic decision to move to our new Alpha video platform, which was madecommercially available in April 2005 in most markets.

The decision tomove our gaming devices to the new video platform, the targeting of usedequipment for non-domestic markets, and the consolidation of certain warehousesall led to accelerated disposals of legacy products. This process has requiredcontinual updating of estimates for the net realizable value of inventories dueto the subjectivity involved in projecting sales volumes, used game salesvalues, refurbishment costs, and customer demand

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in non-domesticjurisdictions.  As a result of ourongoing analysis of inventory valuations, we have recorded inventory andrelated asset write-downs totaling $11.1 million and $14.6 million during thethree and six month periods ended December 31, 2004.  During the three and six month periods endedDecember 31, 2005, we recorded additional inventory write-downs totaling $4.1million and $8.0 million, respectively. We continue to hold a significant number of used gaming devices,therefore, there can be no assurances that further write-downs will not occurin subsequent periods.

*Severancecharges.*  As part of areview of our operations, we reduced our workforce during the six months endedDecember 31, 2004.  As a result of thesereductions, we incurred severance charges totaling $1.4 million during the sixmonth period ended December 31, 2004.  Nosuch severance charges were incurred in the six months ended December 31, 2005.

*DiscontinuedOperations.* During fiscal year 2004, we disposed ofour Nevada route operations and our Rail City Casino.  In fiscal year 2005, we sold our Louisianaroute operations.

The gain previously recorded in June 2004 on the saleof our Nevada route operations was subsequently adjusted during the threemonths ended September 30, 2004, for charges incurred with respect to anadverse outcome in a patent infringement case totaling $4.7 million, net oftax.  This amount is included in thediscontinued operations section of our statement of operations.  Our Louisiana operations also contributed anet profit of $0.7 million and $1.1 million for the three and six month periodsended December 31, 2004, which is also included in discontinued operations.

**FinancialCondition**

***Liquidity***

As of December 31, 2005, we had $24.6 million in consolidated cashand cash equivalents which included approximately $3.8 million of cash utilizedin our Casino Operations segment that is held in vaults, cages or changebanks.  We had net working capital ofapproximately $124.8 million, a decrease of approximately $0.4 million fromJune 30, 2005 levels.  This decrease isdiscussed in “—Working Capital” below

Pursuant to various state gamingregulations, certain cash accounts are maintained to ensure availabilityof funds to pay wide-area progressive jackpot awards. At December 31, 2005,these accounts had an aggregate value of approximately $14.3 million, which areclassified as restricted cash on our condensed consolidated balancesheets.  In addition, we purchase U.S.Treasury Strip Securities for the benefit of jackpot winners who elect toreceive winnings as an annual or weekly installment payments rather than onelump sum.  These securities are includedin restricted long-term investments in the accompanying condensed consolidatedbalance sheets, and totaled $10.5 million as of December 31, 2005.

Cash flows from operatingactivities are derived primarily from the cash receipts from the sale of goodsand services, the operation of wide-area progressive systems, lease payments,and monthly cash receipts from maintenance agreements from our casino systemscustomers.  In addition, we generate cashthrough our casino operations.  Weutilize our cash to acquire materials for the manufacture of goods for resaleor lease, and to pay payroll and selling, general and administrative expenses,as well as to service our debt.

We entered into a loanagreement that governs our $75.0 million revolving credit facility as well asour term loan.  No amounts wereoutstanding as of December 31, 2005 under the revolving credit facility.  Our ability to borrow under the revolvingcredit facility is based on our leverage ratio limit and our compliance withcertain other covenants set forth in the loan agreement.  Based on the current leverage ratio, we hadapproximately $15.4 million of availability under the revolving creditfacility as of December 31, 2005, as compared to $26.3 million as of June 30,2005 which reflects the improved operating results in the 12 month measurementperiod ending December 31, 2005.

The financialcovenants under the loan agreement consist of a leverage ratio, a fixed chargescoverage ratio, and a minimum of Earnings Before Interest, Taxes, Depreciationand Amortization (“EBITDA”) (as that term is defined in the loan agreement) ratio.  The leverage ratio is computed as totalaverage debt outstanding during the quarter

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divided by thetrailing 12 months EBITDA, excluding certain cash and non-cash charges, and isfurther adjusted to remove EBITDA from discontinued operations at the timethose operations are sold.  Our leverageratio as of December 31, 2005 was 4.3 times versus the covenant maximum of4.5 times.   We were in compliance withall financial covenants as of December 31, 2005.

In October 2006, we executed an amendment to our bankloan agreement, which, among other things, (i) extended the due date forthe  delivery of our audited financial statements for the fiscalyear ended June 30, 2006 to December 31, 2006, (ii) provided that wewill deliver our quarterly reports on Form 10-Q for the Fiscal Quarters endedSeptember 30, 2005, December 31, 2005 and March 31, 2006 nolater than December 31, 2006, (iii) modified the definition of EBITDA toexclude up to $10 million of certain cash charges and (iv) clarifiedthat the definition of EBITDA includes interest income on tradereceivables.  We paid an administrative fee of $964,000, which will beexpensed in the quarter ended December 31, 2006, in exchange for theconcessions granted under the amendment.

In December 2006,we executed an additional amendment to our bank facility, which extended thedue date for the  delivery of our quarterly report on Form 10-Q for theFiscal Quarter ended March 31, 2006 and its audited financialstatements for the fiscal year ended June 30, 2006 to March15, 2007. We paid an administrative fee of $1.2 million, which will be expensedin the quarter ended December 31, 2006, in exchange for the concessions grantedunder the amendment.

Management believes that cash flows from currentoperating activities and the availability under the revolving credit facilitywill provide us with sufficient capital resources and liquidity to operate ourbusiness for at least the next 12 months. At December 31, 2005, we had no material commitments for capitalexpenditures.

***Working Capital***

Thefollowing table presents the components of consolidated working capital atDecember 31, 2005, and June 30, 2005, excluding assets and liabilities ofdiscontinued operations:
|                                      | ** ** | **December 31,**           | ** ** | **June 30,** | ** ** | **Increase (decrease)** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2005**                        | ** ** | **2005**          | ** ** | **Amount**              | ** ** | **%** | ** ** |
| ** **                           | ** ** | **(dollars in 000s)** | ** ** |
| Current assets:                      |       |                            |       |              |       |                    |       |   |   |
| Cash and cash equivalents            |       | $                               | 24,641     |              | $          | 33,170                  |       | $ | (8,529 | ) | (26 | )% |
| Restricted cash                      |       | 14,332                          |       | 13,421            |       | 911                     |       | 7 | % |
| Accounts and notes receivable, net   |       | 121,811                         |       | 97,679            |       | 24,132                  |       | 25 | % |
| Inventories                          |       | 59,015                          |       | 63,523            |       | (4,508                  | )          | (7 | )% |
| Income tax receivable                |       | 211                             |       | —            |       | 211                     |       | 100 | % |
| Deferred tax assets                  |       | 30,848                          |       | 30,884            |       | (36                     | )          | — | % |
| Other current assets                 |       | 45,913                          |       | 33,034            |       | 12,879                  |       | 39 | % |
| Total current  assets                |       | $                               | 296,771    |              | $          | 271,711                 |       | $ | 25,060 |   | 9 | % |
|                                 |       |                            |       |              |       |                    |       |   |   |
| Current  liabilities:                |       |                            |       |              |       |                    |       |   |   |
| Accounts payable                     |       | $                               | 27,897     |              | $          | 36,807                  |       | $ | (8,910 | ) | (24 | )% |
| Accrued liabilities                  |       | 52,834                          |       | 43,838            |       | 8,996                   |       | 21 | % |
| Deferred revenue                     |       | 67,370                          |       | 40,962            |       | 26,408                  |       | 64 | % |
| Jackpot liabilities                  |       | 14,636                          |       | 13,025            |       | 1,611                   |       | 12 | % |
| Taxes payable                        |       | —                          |       | 1,752             |       | (1,752                  | )          | (100 | )% |
| Current maturities of long-term debt |       | 9,250                           |       | 10,163            |       | (913                    | )          | (9 | )% |
| Total current  liabilities           |       | 171,987                         |       | 146,547           |       | 25,440                  |       | 17 | % |
| Net working  capital                 |       | $                               | 124,784    |              | $          | 125,164                 |       | $ | (380 | ) | — | % |

 

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For the six monthperiod ended December 31, 2005, working capital decreased $0.4 millionprimarily as a result of the following:

·                  A $24.1 millionnet increase in accounts and notes receivable relating to higher revenue levels(both recognized and deferred), driven by the sales of the ALPHA OS basedproducts;

·                  A $4.5 millionnet decrease in inventory, which resulted from increase in new unit sales (bothrecognized and deferred) driven by the sales of the ALPHA OS based products;

·                  An increase inother current assets, primarily as a result of: (i) a $19.1 million increase indeferred costs directly related to deferred revenues discussed below, (ii) adecrease in trial games of $2.0 million resulting from the conversion to saleof games previously on trial,  (iii) adecrease in prepaid and other royalties of $2.5 million related to the timingof certain payments,  (iv) a decrease inrefundable deposits of $0.6 million as a result the reclass of certain depositsto accounts receivable and (v) a decrease in investments in CD’s maturinggreater than 90 days of $1.0 million;

·                  An overallincrease in accounts payable and accrued liabilities of $0.1 million primarilyas a result of a decrease in account payable which was offset by an increase inaccrued liabilities, both as a result of the timing of certain vendor payments;

·                  An increase injackpot liabilities of $1.6 million primarily due to an increase in thefrequencies of jackpots won; and

·                  Anincrease in deferred revenue of $26.4 million (and $19.1 million in deferredcost of sales) as a result of an increase in transactions that did not meet therevenue recognition requirements of SOP No. 97-2.

***CashFlow Summary***
|                       | ** ** | **Six months ended December 31,** | ** ** | **Increase (decrease)** | ** ** |
|-----------------------|------------|-------------------------------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2005**                                              | ** ** | **2004**                     | ** ** | **Amount** | ** ** |
| ** **            | ** ** | **(dollars in millions)**                   | ** ** |
| Cash flows from:      |       |                                                  |       |                         |       |   |   |
| Operating activities  |       | 23,167                                                |       | (4,262                       | )          | 27,429 |   |
| Investing activities  |       | (28,849                                               | )          | (34,489                      | )          | 5,640 |   |
| Financing  activities |       | (2,870                                                | )          | (103,925                     | )          | 101,055 |   |

 

During the sixmonth period ended December 31, 2005, cash flows provided by operatingactivities totaled $23.2 million, as compared to $4.3 million used by operatingactivities in the corresponding period in the prior year.  The improvement in net cash flows fromoperations for the six month period is primarily related to:

·                  The use of cashin the prior year period to purchase an appeal bond related to patentlitigation ($7.4 million);

·                  An increase of$8.1 million non-cash items such as depreciation and amortization from $22.8million to  $30.9 million and share-basedcompensation which increased by $5.4 million from $0.5 million to $5.9 million;

·                  A $48.7 millionincrease in accounts and notes receivable relating to higher revenue (bothrecognized and deferred) driven by sales of the ALPHA OS based products, aswell as the timing of receivable collections cycle increased;

·                  Timing of vendorpayments as the payment cycle to vendors decreased;

·                  An increase indeferred revenue of $34.3 million (and $24.6 million in deferred cost of sales)as a result of an increase in transactions that did not meet the revenuerecognition requirements of SOP No. 97-2; and

·                  Inventoryactivity decreased $26.1 million as a result primarily of the prior yearinventory which included several large orders of gaming devices not delivereduntil after the respective quarter end.

During the sixmonth period ended December 31, 2005, cash flows used in investing activitiestotaled $28.8 million, as compared to $34.5 million for the correspondingperiod in the prior year.  This change isprimarily the result of:

·                  Capitalexpenditures of $6.2 million compared to $5.5 million for the correspondingperiod in the prior year which is the result of a decrease in expenditures forinternal software and leasehold improvements;

·                  Costs incurredto deploy additional leased gaming devices totaling $19.9 million compared to$18.0 million in the prior year period resulting from an increase in the totalbase of recurring games deployed; and

·                  A renegotiatedearn-out cash payment of $12.0 million during the six month period ended December31, 2004.

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Duringthe six month period ended December 31, 2005, cash flows used in financingactivities totaled $2.9 million as compared to $103.9 million for thecorresponding period in the prior year. The prior year quarter financingactivities reflected $101.6 million in cash used to repay debt resulting fromthe sale of certain of our non core assets in the prior year.  The current period cash uses primarily relateto principal payments on long term debt totaling $3.0 million and cash providedfrom exercise of stock options of $0.2 million.

***ContractualCommitments***

There were no materialchanges during the three and six month periods ended December 31, 2005, to ourcontractual obligations and commitments disclosed in the 2005 10-K.

**CriticalAccounting Policies**

A description ofour critical accounting policies can be found within management discussion andanalysis of financial condition and results of operation in the 2005 10-K.There were no material changes to those policies during the three month periodended December 31, 2005.

*Recently Issued AccountingPronouncements*

In September 2006,the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements*, which defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.SFAS No. 157 does not require any new fair value measurements, rather itapplies under existing accounting pronouncements that require or permit fairvalue measurements.  SFAS No. 157 iseffective for fiscal years beginning after November 15, 2007, and accordingly,the Company expects to adopt SFAS No. 157 beginning in fiscal year 2009. We arecurrently in the process of evaluating the impact SFAS No. 157 will have on ourconsolidated results of operations, financial position and cash flows.

In September 2006,the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*, providing guidance on how prioryear misstatements should be taken into consideration when quantifyingmisstatements in current year financial statements for purposes of determiningwhether the current year’s financial statements are materially misstated. SABNo. 108 is effective for fiscal years ending on or after November 15, 2006, andaccordingly, the Company expects to adopt SAB No. 108 beginning in fiscal year2007. We do not expect SAB No. 108 will have an impact on our consolidatedresults of operations, financial position or cash flows.

In July 2006,the FASB issued FIN 48, *Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109**, Accounting for IncomeTaxes*, which creates a single model to address uncertainty in incometax positions and prescribes the minimum recognition threshold a tax positionis required to meet before being recognized in the financial statements. Italso provides guidance on derecognition, measurement, classification, interestand penalties, accounting in interim periods, disclosure and transition. FIN 48is effective for fiscal years beginning after December 15, 2006, andaccordingly, the Company expects to adopt FIN 48 beginning in fiscal year 2008.We are currently in the process of evaluating the impact FIN 48 will have onour consolidated results of operations, financial position and cash flows.

In June 2005,the FASB issued FASB Staff Position (“FSP”) No. FAS 143-1, *Accounting for Electronic Equipment WasteObligations,* toaddress accounting for obligations associated with the European Union’sDirective 2002/96/EC on Waste Electrical and Electronic Equipment. TheDirective, enacted in 2003, requires EU-member countries to adopt legislationto regulate the collection, treatment, recovery, and environmentally sounddisposal of electrical and electronic waste equipment. The Directivedistinguishes between products put on the market after August 13, 2005 asnew waste and before that date as historical waste. FSP No. FAS 143-1 onlyaddresses accounting for historical waste and is required to be applied thelater of the first reporting period ending after June 8, 2005 or the dateof adoption of the law by the applicable European Union member country.   Adoption of FSP No. FAS 143-1 didnot have a material impact on our consolidated results of operations, financialposition or cash flows.

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InDecember 2004, the FASB issued SFAS No. 153, *Exchanges of Nonmonetary Assets*,amending APB Opinion No. 29, *Accounting forNonmonetary Transactions*.  APBOpinion No. 29 treated nonmonetary exchanges of similar productive assets as anexception from fair value measurement. SFAS No. 153 replaces this exception with a general exception from fairvalue measurement for exchanges of nonmonetary assets that do not havecommercial substance. Nonmonetary exchanges have commercial substance if thefuture cash flows of an entity are expected to change significantly as a resultof the exchange. SFAS No. 153 was effective for nonmonetary asset exchangesoccurring in fiscal years beginning after June 15, 2005. Adoption of SFASNo. 153 did not have a material impact on our consolidated results ofoperations, financial position or cash flows.

In November 2004, the FASB issuedSFAS No. 151, *Inventory Costs*,revising Accounting Research Bulletin No. 43, Chapter 4, *Inventory Pricing*, which clarifies theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and wasted material. SFAS No. 151 was effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  Adoption of SFAS No. 151 did not have amaterial impact on our consolidated results of operations, financial positionor cash flows.

**ITEM 3.          QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

*Interest Rate Risk*

As of December 31, 2005, we hadtotal debt of approximately $332.1 million, consisting primarily of the $313.1million term loan under our senior credit facilities and approximately $19.0million in other debt.  The interest ratefor the term loan is reset every six months. If the LIBOR rates were to increase or decrease by 100 basis points,with all other factors remaining constant, earnings would decrease or increaseby approximately $3.3  million annually,on a pre-tax basis.

*ForeignCurrency Exchange Rate Risk*

Our foreignsubsidiaries generally use their domestic currency as their functionalcurrency. A 10% fluctuation in the exchange rates of these currencies againstthe U.S. dollar would result in a corresponding change in earnings reported inthe consolidated group which would have no significant effect on a pre-taxbasis.

# **ITEM 4.          CONTROLS AND PROCEDURES**

**Disclosure Controls and Procedures**

As required by Rule 13a-15(b) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”), ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of the design and operation ofour disclosure controls and procedures, as defined in Exchange Act Rule13a-15(e), as of the end of the period covered by this report.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of December 31, 2005,our disclosure controls and procedures were not effective due to the existingmaterial weaknesses in our internal control over financial reporting that werepreviously identified and  discussed inthe 2005 10-K and below under “—Internal Control Over Financial Reporting—Internal Control Over Financial Reporting Assessment as of the Filing of ThisReport - Update Regarding Remediation Plan.”

In view of the fact that the financial information presentedin this quarterly report on Form 10-Q for the fiscal quarter ended December 31,2005, was prepared in the absence of effective internal control over financialreporting, we have devoted a significant amount of time and resources to theanalysis of the financial statements contained in this report.  In particular, we have reviewed thesignificant account balances and transactions reflected in the financialstatements contained in this report and otherwise analyzed the transactionsunderlying our financial statements to verify the accuracy of the financialstatements.  Accordingly, managementbelieves that the financial statements included in this report fairly present,in all material respects, our financial condition, results of operations, andcash flows.

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Nevertheless, there can be no assurance that eitherthis review process or our existing disclosure controls and procedures willprevent or detect all errors and all fraud, if any, or result in accurate andreliable disclosure. A control system can provide only reasonable and notabsolute assurance that the objectives of the control system are met. Becauseof the inherent limitations in all control systems, no evaluation of controlscan provide absolute assurance that all control issues and instances of fraud,if any, have been detected. Additionally, judgments in decision-making can befaulty and breakdowns in internal controls can occur because of simple errorsor mistakes that are not detected on a timely basis.

**Internal Control Over Financial Reporting**

Our management acknowledges its responsibility forestablishing and maintaining adequate internal control over financial reportingthat includes effective accounting policies and procedures. Our continuingprogress in establishing adequate internal control over financial reporting isdescribed below.

*CertainChanges in Internal Control Over Financial Reporting during the Fiscal QuarterEnded December 31, 2005*

During the quarter ended December 31, 2005, ourmanagement team was in the process of identifying the material weaknessesdescribed in the 2005 10-K.  During thequarter ended December 31, 2005, management initiated preliminary remediationsteps to address the material weaknesses known at that time.  Specifically, management initiated thechanges discussed below under “―Internal Control Over Financial ReportingAssessment as of the Filing of This Report - Update Regarding RemediationPlan―Inadequate Controls Related to Revenue Recognition - ContractAdministration.”  There were no other changesto our internal control over financial reporting during the three month periodended December 31, 2005 that management believes have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

*InternalControl Over Financial Reporting Assessment as of the Filing of This Report –Update Regarding Remediation Plan*

We are including information in this Quarterly Reporton Form 10-Q with respect to our internal control over financial reporting forthe period subsequent to December 31, 2005, in order to provide readers with acurrent understanding of the identified weaknesses, as well as how they arebeing addressed as part of our remediation plan.

Subsequentto June 30, 2005, we have undertaken extensive work to remediate the materialweaknesses identified in our internal control over financial reportingdescribed in the 2005 10-K including developing the specific remediation initiativesdescribed below. The implementation of these initiatives was a priority for usin fiscal 2006 and continues to be a priority in fiscal 2007.  We have begun implementing the actionsdescribed below with respect to the identified material weaknesses; however,there can be no assurances as to when or if, the implementation of theseinitiatives will be completed.  Furthermore, we are in process of evaluating our internal control overfinancial reporting as of June 30, 2006. There can be no assurances that the material weaknesses described in the2005 10-K were cured as of such date, or that we will not identify additionalmaterial weaknesses as a result of such evaluation.  Until such initiatives are implemented, wewill continue to incur the expenses and management burdens associated with theadditional resources required to prepare our consolidated financial statements.

*Inadequate Staffing**and Training in Finance and Accounting*

*InadequateStaffing**.*  We have focused intensive efforts onimproving the overall level and quality of our staffing in a number of financeand accounting areas related to the identified material weaknesses, includingthe tax and revenue departments.  Theseefforts have resulted in the creation of several new positions, as well as thehiring of a number of key employees.  Asof the date of this filing, we have filled the following positions:  Chief Financial Officer, VicePresident/Corporate Controller, Vice President of Corporate Accounting,Director of Financial Reporting, a Contract Administrator and a Tax Manager.

*InadequateTraining**.*  We have held a number of internal meetingswith our sales staff to review our revenue recognition policies andprocedures.  Our goal is to provide thesales staff with a better understanding of the applicable accounting rules, theconsistency in contractual language that is required, as well as the newcontract administration procedures discussed below under “—Inadequate ControlsRelated to Revenue Recognition —

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ContractAdministration.”  We are also educatingthe sales department as to certain standard sales contracts discussed below andwith respect to the types of contractual language that has been reviewed andpre-approved by members of the legal and finance departments.

Additionally,the finance and accounting department continues to encourage and pay for allpersonnel who enroll in Continuing Professional Education, as well as for anycollege and master’s level courses that relate to their respective jobfunctions.

*IneffectiveControls related to the Preparation of Certain Account Analyses, AccountSummaries and Account Reconciliations*

As a result of theadjustments made with respect to certain balance sheet accounts and relatedstatement of operations for the fiscal year ended June 30, 2005, we determineda more detailed review for these accounts was necessary in connection with ourquarterly account reconciliation process. The Company completed a thorough review of balance sheet accounts todetermine whether the supporting schedules were adequately prepared and/orreviewed, and that they included adequate supporting documentation.

The finance andaccounting department has also developed a spread sheet management process toensure that various departments are working from the same schedules therebyreducing the likelihood of errors from using outdated files stored onindividual computers.

*Inadequate Controls Related to Revenue Recognition*

Inaddition to the additional internal training of our sales staff discussedabove, we have also taken the following actions to remediate the issuespreviously identified with respect to inadequate controls related to revenuerecognition.

*InternalReview of All Game Sale Transactions.*  Management has implemented a procedure toreview each game and system sale transaction for compliance with AICPAStatement of Position No. 97-2, *SoftwareRevenue Recognition*.  Theinitial revenue recognition determination is made by the revenue department,and is then reviewed by a member of our finance department at a director orhigher level.  In addition, our ChiefFinancial Officer reviews both randomly selected contracts, as well as thoserelated to large and/or complex transactions.

*OutsideReview of Game Sale Transactions.*  We engaged an outside consultant to assist usin performing additional review procedures for revenue transactions duringfiscal 2006. The scope of the consultant’s review was designed to ensure acomprehensive review of all large transactions, as well as certain types oftransactions that have previously resulted in adjustments to the timing ofrevenue recognition. The outside consultant’s scope also included reviewing asample of contracts from the remaining population for proper revenuerecognition.

Wehave also reviewed certain complex transactions and new proposed contracts withour consultants to identify any accounting issues prior to the final contractexecution.

*Implementationof Standard Sales Contract**.*  As part of the pre-review processes,discussed above under “―Internal Review of All Game Sale Transactions,”we have created a standard contract for domestic game sales. This contract wasintroduced to the sales force in draft form in January 2006, and wasimplemented in February 2006.  We arealso reviewing our system sales contracts and international sales contracts todetermine the feasibility of developing standardized contracts for all thosemarkets.

*ContractAdministration**. *Wehave designed a multiple step action plan to develop a contract administrationprocess that is well defined, well understood and efficient in its operation.Our previous contract administration process could not be relied upon toproduce consistently prepared contracts as documents could be edited by anumber of individuals at anytime prior to execution.

Beginningin September 2005, we implemented Phase I of our plan which required each salescontract to follow the contract approval flow chart process.  Phase I includes a review of all terms andconditions of each contract, and

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requiresformal sign off as well as execution of the sales agreement by certain levelsof management based on a predetermined approval process.  We have also established procedures that willnow require approval by our Chief Executive Officer for certain contracts. Thecontract is then returned to the sales person for delivery and sign off by thecustomer.  Any further edits would thenbe re-reviewed by members of our finance and accounting department to gaugetheir accounting impact to ensure proper revenue recognition.

InFebruary 2006 we began Phase II of our process and hired a ContractAdministrator.  Phase II of the contractadministration process involves the establishment of a Contract Administratorposition, and related enhanced policies and procedures. This individual reportsdirectly to the legal department. Members of our Senior Management team havealso agreed to certain contractual terms that have been defined as “standard”and, consequently, we developed standard game sales contracts discussed aboveunder “―Implementation of Standard Sales Contract.”  If the draft contract uses these standardterms, it will receive only limited review by our finance and accountingdepartment.  If the contract goes beyondthese standard terms, then the Contract Administrator must follow a newlycreated decision tree which involves review and approval by various members ofthe finance and legal departments, depending on the issue identified.

PhaseIII of the process introduces a new contract management and work flow softwareto better manage the decision tree and track contract approvals.

QuarterlyCertifications.  We have expanded our quarterly Sarbanes-Oxleycertification procedures and disclosure controls.  In addition to the internal certifications wepreviously required from the Executive Vice President of each business divisionand the Vice President/Corporate Controller, our process now requires internalsub-certifications from all sales directors and Vice Presidents, including theExecutive Vice President of Sales.  Theseadditional internal sub-certifications include a number of representationsregarding the various signatories’ respective duties and responsibilities.

*Inadequate Controls Related to Inventory Valuation*

Wehave taken the following actions to remediate the issues previously identifiedwith respect to our inadequate controls related to inventory valuation.

*Expandedreview by Senior Management**.*Members of our senior management teamhave met with members of the manufacturing management team, cycle counters, andwarehouse supervisors, as well as performed expanded reviews of the supportingschedules prepared by the cost accounting manager in regards to inventoryvaluation, and have selected various accounts for additional analysis.  We have also filled the new role ofAccounting Manager – Inventory.  Thisindividual’s entire focus will be on inventory related issues.

*GameInventory – Live Data**. *The Company’sintra-net site is in the process of being upgraded to include real time datafor game inventory; both for new and used games. This upgrade has allowed forincreased accounting for the game inventory, as well as greater awareness by agreater number of individuals of the inventory levels and the availability ofcertain finished goods.

*NegativeBill of Materials**.*  We identified an issue regarding theaccounting for excess inventory that was issued with respect to work orders butwas subsequently restocked.  Ultimately,the manufacturing system will be programmed to perform these entriesautomatically; however, until the programming is complete, we will continue tomake manual adjustments with respect thereto.

*PhysicalInventories**. *We utilize aperpetual inventory system with a substantial portion of our inventory beingsubjected to daily cycle counts. Management performed added physical countsduring fiscal year 2006 and the Inventory Accounting Manager and members of thecycle count teams visited certain of our offsite warehouses to performadditional detailed physical counts and tests during fiscal 2006.  We will continue to perform additionaldetailed physical counts at our offsite warehouses during fiscal 2007.

*QuarterlyAdjustments of Purchase Price Variances**.*Our VicePresident/Corporate Controller and our Inventory Accounting Manager areperforming quarterly analyses of any purchase price variances that may occurwhen there is

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adeviation from our standard prices and are making the necessary adjustments toproperly value our cost of sales, inventory and fixed assets.

*IneffectiveControls Related to Income Taxes*

We have increasedour internal capabilities in the income tax area with the addition of our ChiefFinancial Office, Vice President of Corporate Accounting and Manager of Tax, aswell as with the continued assistance of third party consultants. These individualsperform significant internal reviews of our income tax provision eachquarter.  We continue to use the servicesof large local law firms and accounting firms in foreign jurisdictions in orderto ensure that we are in compliance with local tax laws. We are also performingan annual R&D tax study and consulting with a nationally recognizedaccounting firm on certain transfer pricing studies as well.

*IneffectiveControls at the Entity Level*

We have taken thefollowing actions to remediate the issues previously identified with respect toour ineffective controls at the entity level.

*ITSystems**.*  We continue to address areas of our IT systemthat require additional investment. Consultants from the IT Systems provider(MAPICS) have been engaged to perform a review of our current usage of oursystem, and the cost benefits of upgrades that are available.

*ControlEnvironment**.* On December 1, 2006, our Board of Directorsappointed Mr. Robert Guido as an independent director to fill a vacancy on theboard.  Mr. Guido will also serve on the Audit Committee.  The Boardof Directors affirmatively determined that Mr. Guido is an Audit Committeefinancial expert under the rules of the SEC.

*InternalAudit*.  In additionto the personnel changes discussed above, we have hired a new Vice President tohead our Internal Audit department. This individual led our Sarbanes-Oxleytesting for fiscal year 2006 as well as coordinated efforts with the outsidefirm we hired in the 2005 compliance effort.  To better utilize the resourcesof the outside firm during fiscal year 2007 and 2006, several changes have beenmade to its engagement, including changing the protocols and personnel on theengagement team.

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**PART II**

# **ITEM 1.          LEGAL PROCEEDINGS**

***Litigation***

OnSeptember 25, 1995, Bally Gaming Inc, a wholly-owned subsidiary of the Company(“BGI”), was named as a defendant in a class action lawsuit filed in the UnitedStates District Court for the District of Nevada. The plaintiffs filed suitagainst BGI and approximately 45 other defendants, each of which is involved inthe gaming business as a gaming machine manufacturer, distributor or casinooperator. The lawsuit arises out of alleged fraudulent marketing and operationof casino video poker machines and electronic slot machines. The plaintiffsalleged that the defendants have engaged in a course of fraudulent andmisleading conduct intended to induce people into playing their gaming machinesbased on a false belief concerning how those machines actually operate, as wellas the extent to which there is actually an opportunity to win on any givenplay. The plaintiffs allege that the defendants’ actions constitute violationsof the Racketeer Influenced and Corrupt Organizations Act (RICO) and give riseto claims of common law fraud and unjust enrichment. The plaintiffs are seekingmonetary damages in excess of $1.0 billion. In July 2002, the FederalDistrict Court denied the plaintiffs’ request for class action certification.In August 2004, the United States Court of Appeals for the Ninth Circuitaffirmed the Federal District Court’s denial of class action certification, andthe plaintiffs did not appeal. Subsequently, two of the four named plaintiffselected to continue their cases as individual, non-class actions. However, inSeptember 2005, the court granted the defendants’ motions for summary judgment,resolving all claims in defendants’ favor without a trial. In October 2005, theplaintiffs appealed the District Court’s granting of summary judgment in favorof the defendants to the Ninth Circuit. Thereafter, the plaintiffs/appellantsagreed to dismiss their appeal in exchange for the defendants’ agreement not topursue a claim for costs.  The appeal wasdismissed on June 26, 2006.

In June and July2004, putative class actions were filed against Bally and its officers, RobertMiodunski, Robert Saxton, Mark Lerner and Steven Des Champs, in the UnitedStates District Court for the District of Nevada. The nearly identicalcomplaints alleged violations of the Securities Exchange Act of 1934, as amended,stemming from revised earnings guidance, declines in the stock price and salesof stock by insiders. The complaints sought damages in unspecified amounts. TheFederal District Court granted the plaintiffs’ unopposed motions to consolidatethe cases and to appoint a lead counsel and a lead plaintiff, and theplaintiffs filed a consolidated complaint, all as is customary in such cases.Bally and the other defendants have moved to dismiss the complaint.  Thereafter, activity in the case was stoppedand the parties participated in a mediation process.  The parties have reached an agreement inprinciple and are negotiating settlement documents, which will require courtapproval

Inaddition, in July 2004, two derivative lawsuits were filed in Nevada statecourt against the members of the board of directors and the officers listedabove. The Company was named as a nominal defendant in the derivative lawsuitsas the claims were purportedly asserted for the benefit of Bally. Theselawsuits asserted claims for breach of fiduciary duty and waste of corporateassets arising out of the same events as those giving rise to the class actionsdescribed above, and sought injunctive relief and damages in unspecifiedamounts. These two cases were consolidated, and Bally and the other defendantsmoved to dismiss the case. In February 2005, the state district court grantedthe defendants’ motion and dismissed the case. The plaintiffs appealed thedismissal to the Nevada Supreme Court, which referred the matter to its settlementconference program. The parties met with a court-appointed settlement judge onDecember 15, 2005, and agreed to settle the case for $8,000, and on February 2,2006, the Nevada Supreme Court entered its order formally dismissing theappeal, thereby terminating the case. Although management believes theplaintiffs’ lawsuit and appeal were without merit, it determined that thesettlement was in the best interests of the Company.

OnMarch 27, 2006, shortly after the aforementioned derivative suit was dismissedin the Nevada state court, another derivative lawsuit was filed in the UnitedStates District Court for the District of Nevada against individual defendantsRobert Miodunski, Robert Saxton, Steven Des Champs, Mark Lerner, David Robbins,Anthony DiCesare, Joel Kirschbaum, Kevin Verner, Richard Haddrill, StephenRace, Jacques André and nominal defendant Bally Technologies, Inc., in theUnited States District Court for the District of Nevada.  Based on factual allegations

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thatare similar to those alleged in the federal securities class action complaintsand the previous derivative actions that were dismissed by the District Court,the derivative complaint alleges breach of fiduciary duty, abuse of control,gross mismanagement, waste of corporate assets, unjust enrichment and violationof the Sarbanes-Oxley Act of 2002. The parties have reached an agreement inprinciple and are negotiating settlement documents.

During the sixmonths ended December 31, 2005, the Company accrued $1.3 million related to theanticipated settlement of the class action litigation and the March 27,2006 derivative suit.  The Company alsoaccrued approximately $0.5 million for legal fees related to the litigation inthe six months ended December 31, 2005, which totaled $1.9 million for thefiscal year ended June 30, 2006.

In August 2004,Shuffle Master, Inc. sued the Company in the United States District Court forthe District of Nevada, alleging infringement of various patents in connectionwith the Company’s MindPlay product line and seeking injunctive relief anddamages in an unspecified amount. In June 2005, it was announced thatInternational Gaming Technology (“IGT”) had acquired an interest in the patentsat issue in the case, and thereafter IGT joined the case as a plaintiff. In December 2005, the District Court issued a ruling construing theclaim terms of all the patents in the suit. Management believes theplaintiffs’ lawsuit to be without merit, and the Company is vigorouslydefending against the lawsuit.

InSeptember 2004, a United States District Court jury in the District of Nevadaentered a $7.4 million verdict against the Company in a suit filed by AGI andIGT. The suit alleged that the multi-hand video poker game deployed by theCompany’s former subsidiary, United Coin Machine Co. (“United Coin”), infringedthe plaintiffs’ patents. The Federal District Court ruled on summary judgmentthat the game does not infringe the patents. However, the court left to thejury the question whether the use of “autohold,” a specific, optional featureof the game, caused it to infringe under the “doctrine of equivalents,” adoctrine of patent law. After a two-week trial, the jury determined that thegame with the autohold option enabled did infringe under the doctrine ofequivalents and awarded damages accordingly. The feature has been disabled onall affected games in the field, and the decision permits continued deploymentof the game as long as the autohold feature is not included. The Companyappealed the decision to the United States Court of Appeals for the NinthCircuit and has posted a cash bond totaling $7.6 million to stay payment of thejudgment and accrued interest pending the appeal. The cash bond is included inother non-current assets and the accrued liability is included in accruedliabilities in the accompanying balance sheets. This amount has been accruedand the expense for this charge is included in discontinued operations in theaccompanying statement of operations for 2004.  On July 11, 2006, the federal circuit court of appeals affirmed thedistrict court judgment, denying the appeals for both parties, and thereafterthe judgment was satisfied out of the posted bond.

On December 7,2004, IGT filed a patent infringement lawsuit against Bally in the UnitedStates District Court for the District of Nevada. The complaint asserts thatBally’s wheel-based games, such as Monte Carlo, Lucky Wheel and Cash ForLife, its games with a reel in the top box, such as Bonus Frenzy, and its iViewproducts infringe on patents held by IGT, and seeks injunctive relief anddamages in unspecified amounts. Bally believes IGT’s claims are withoutmerit and is vigorously defending itself against the lawsuit. As part of itsdefense, Bally has asserted counterclaims against IGT, including claims thatIGT’s patents are invalid, unenforceable and not infringed, as well asseveral claims that IGT has engaged in anti-competitive conduct in violation ofstate and federal antitrust laws. By its counterclaims, Bally is seekingdamages and other relief from IGT. IGT’s motion to dismiss Bally’s antitrustclaims was denied on January 10, 2006. The litigation is in the discoveryphase and no trial date has been set.

InFebruary 2005, the SEC initiated an informal inquiry and requested documentsand information regarding matters related to the allegations in the classactions and similar matters. In August 2005, the SEC notified the Company thatits investigation had entered a formal phase, and requested additionalinformation from the Company covering the same general areas that wereaddressed in the informal inquiry. Management is cooperating fully with the SECin this matter.

In May2006, IGT filed a patent infringement lawsuit against Bally in the UnitedStates District Court for the District of Delaware.  The complaint asserts that Bally’s PowerBonusing products infringe patents held by IGT, and seeks injunctive relief anddamages in unspecified amounts.  IGT’smotion for a preliminary injunction is pending. Bally believes IGT’s claims are without merit, including its request forpreliminary relief and is vigorously defending itself against the lawsuit.

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InSeptember 2006, Bally filed a patent infringement lawsuit against IGT in theUnited States District Court for the District of Nevada.  The complaint asserts that certain of IGT’sbonus wheel games infringe patents held by Bally, and seeks injunctive reliefand damages.  IGT filed an answergenerally denying the claims.  The caseis in the discovery phase and no trial date has been set.

The Company is alsoa party to various lawsuits relating to routine matters incidental to ourbusiness.  Management does not believethat the outcome of such litigation, including the matters above, in theaggregate, will have a material adverse effect on our financial position.

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**ITEM 6.          Exhibits**
| Exhibits | ** ** | **Description**                                                                                                                                       |
|----------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |       |                                                                                                                                                  |
| 31.1     |       | Certification of Chief Executive Officer, pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.                             |
|     |       |                                                                                                                                                  |
| 31.2     |       | Certification of Chief Financial Officer, pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.                             |
|     |       |                                                                                                                                                  |
| 32.1     |       | Certification of Chief Executive Officer, pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley  Act of 2002. |
|     |       |                                                                                                                                                  |
| 32.2     |       | Certification of Chief Financial Officer, pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the  Sarbanes-Oxley Act of 2002. |

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto authorized.
| BALLY TECHNOLOGIES, INC. |                                                             | Date: December 21, 2006 |
|--------------------------|------------------------------------------------------------------|-------------------------|
|                     |                                                             |                    |
|                     |                                                             |                    |
| By                       | /s/ Richard Haddrill                                             |                    |
|                     | Richard Haddrill                                                 |
|                     | President and Chief Executive Officer                            |
|                     | (Principal Executive Officer)                                    |
|                     |
|                     |
| By                       | /s/ Robert C. Caller                                             |                    |
|                     | Robert C. Caller                                                 |
|                     | Executive Vice President, Chief Financial Officer  and Treasurer |
|                     | (Principal Financial and Accounting Officer)                     |
|                          |                                                                  |                         |  |  |  |

 

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