**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM10-QSB**

** **

**(MarkOne)**

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

 

**For the quarterly period ended:  September30, 2004**

 

**OR**

 

**o****                                ****TRANSITIONREPORT PURSUANT SECTION 13 OR 15(d) OF THE EXCHANGE ACT**

 

**For the transition periodfrom:                                    to                                    **

 

**Commission file number:  001-32161**

 

**VendingData Corporation**

(Exact name ofsmall business issuer as specified in its charter)

 

| **Nevada**                                                      | ** ** | **91-1696010**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**6830Spencer Street, Las Vegas, Nevada  89119**

(Address ofprincipal executive offices)

 

**(702) 733-7195**

(Issuer’stelephone number)

 

 

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

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during the past12 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 ý No o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date:17,198,198 shares of common stock, $.001 par value, as of September 30, 2004

 

Transitional Small Business Disclosure Format (check one): Yes o No ý

 

 

 

**VENDINGDATA CORPORATION**

 

**FORM 10-QSB**

 

**TABLE OF CONTENTS**

 
| **PART I –  FINANCIAL INFORMATION** | ** **                                                        |
|------------------------------------------|-------------------------------------------------------------------|
| ** **                               | ** **                                                        |
| Item 1.                                  | Financial  Statements.                                            |   |
|                                     |                                                              |   |
|                                     | Balance Sheets                                                    |   |
|                                     |                                                              |   |
|                                     | Statements of Operations                                          |   |
|                                     |                                                              |   |
|                                     | Statements of Cash Flows                                          |   |
|                                     |                                                              |   |
| ITEM 2.                                  | MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF  OPERATIONS. |   |
|                                     |                                                              |   |
|                                     | Overview                                                          |   |
|                                     |                                                              |   |
|                                     | Critical Accounting Policies  and Estimates                       |   |
|                                     |                                                              |   |
|                                     | Results  of Operations                                            |   |
|                                     |                                                              |   |
|                                     | Liquidity and Capital  Resources                                  |   |
|                                     |                                                              |   |
| ITEM  3.                                 | CONTROLS AND PROCEDURES                                           |   |
|                                     |                                                              |   |
| **PART II – OTHER INFORMATION**     |                                                              |
|                                     |                                                              |   |
| Item 1.                                  | Legal Proceedings.                                                |   |
|                                     |                                                              |   |
| Item 2.                                  | Changes in Securities.                                            |   |
|                                     |                                                              |   |
| Item 3.                                  | Defaults Upon Senior  Securities.                                 |   |
|                                     |                                                              |   |
| Item 4.                                  | Submission of Matters to a Vote of  Security Holders.             |   |
|                                     |                                                              |   |
| Item 5.                                  | Other  Information.                                               |   |
|                                     |                                                              |   |
| Item 6.                                  | Exhibits and Reports on Form 8-K.                                 |   |

 

i

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# **PART I** — FINANCIAL INFORMATION

# ** **

## **Item1.** Financial Statements.

 

**VENDINGDATA CORPORATION**

### **Balance Sheets**

 
| ** **                                                                                                            | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                            | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                            |       |                   |       |                  |       |
| **Current assets:**                                                                                                   |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                             |       | $                      | 2,685,355  |                  | $          | 11,526,664 |   |
| Current portion of accounts receivable, trade, net  of allowance for uncollectables of $149,190 and $125,530          |       | 3,863,576              |       | 2,354,054             |       |
| Due from affiliate                                                                                                    |       | 40,602                 |       | 31,802                |       |
| Other receivables                                                                                                     |       | 99,212                 |       | 29,836                |       |
| Inventories                                                                                                           |       | 5,721,798              |       | 4,150,414             |       |
| Prepaid expenses                                                                                                      |       | 391,658                |       | 52,028                |       |
|                                                                                                                  |       | 12,802,201             |       | 18,144,798            |       |
|                                                                                                                  |       |                   |       |                  |       |
| Equipment rented to customers, net of accumulated  depreciation of $506,727 and $316,245                              |       | 458,217                |       | 608,555               |       |
| Property and equipment, net of accumulated  depreciation of $2,163,868 and $1,859,206                                 |       | 931,803                |       | 1,063,951             |       |
| Intangible assets, net of accumulated amortization  of $399,284 and $288,203                                          |       | 1,168,847              |       | 1,282,088             |       |
| Due from affiliate - non current                                                                                      |       | 118,800                |       | 118,800               |       |
| Accounts receivable, trade, net of current portion,  less unamortized discount                                        |       | 1,468,394              |       | 1,140,984             |       |
| Deferred expenses                                                                                                     |       | 624,334                |       | 250,697               |       |
| Deposits                                                                                                              |       | 931,058                |       | 1,284,827             |       |
| Other assets                                                                                                          |       | —                 |       | 265,478               |       |
|                                                                                                                  |       | $                      | 18,503,654 |                  | $          | 24,160,178 |   |
|                                                                                                                  |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                         |       |                   |       |                  |       |
| **Current liabilities:**                                                                                              |       |                   |       |                  |       |
| Current portion of leases payable                                                                                     |       | $                      | 1,861,697  |                  | $          | 2,237,073 |   |
| Accounts payable                                                                                                      |       | 1,109,602              |       | 1,727,460             |       |
| Accrued expenses                                                                                                      |       | 512,894                |       | 824,307               |       |
| Deferred revenues, current portion                                                                                    |       | 239,215                |       | 171,875               |       |
| Short-term debt                                                                                                       |       | 238,250                |       | 270,743               |       |
| Current portion of convertible debt                                                                                   |       | —                 |       | 2,368,077             |       |
| Customer deposits                                                                                                     |       | 196,360                |       | 178,805               |       |
|                                                                                                                  |       | 4,158,018              |       | 7,778,340             |       |
|                                                                                                                  |       |                   |       |                  |       |
| Deferred revenues, net of current portion                                                                             |       | 243,175                |       | 219,890               |       |
| Notes payable, net of current portion                                                                                 |       | 3,250,000              |       | —                |       |
| Leases payable, net of current portion                                                                                |       | 560,133                |       | 1,916,723             |       |
|                                                                                                                  |       | 8,211,326              |       | 9,914,953             |       |
| **Stockholders’ equity:**                                                                                        |       |                   |       |                  |       |
| Preferred stock, $.001 par value, 10,000,000 shares  authorized, no shares issued and outstanding                     |       | —                 |       | —                |       |
| Common stock, $.001 par value, 25,000,000 shares  authorized, 17,198,198 and 16,765,580 shares issued and outstanding |       | 17,198                 |       | 16,766                |       |
| Additional paid-in capital                                                                                            |       | 59,760,641             |       | 58,810,806            |       |
| Deficit                                                                                                               |       | (49,485,511            | )          | (44,582,347           | )          |
| Total stockholders’ equity                                                                                       |       | 10,292,328             |       | 14,245,225            |       |
| Total liabilities and stockholders’ equity                                                                       |       | $                      | 18,503,654 |                  | $          | 24,160,178 |   |

 

See accompanyingnotes to financial statements.

 

1

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**VENDINGDATA CORPORATION**

### **Statements of Operations**

 

**(UNAUDITED)**

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2004**                                   | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                |       |                                       |       |                                 |       |   |   |   |   |
| **Revenues:**                       |       |                                       |       |                                 |       |   |   |   |   |
| Sales                               |       | $                                          | 981,532    |                                 | $          | 2,187,003 |   | $ | 3,852,242 |   | $ | 5,342,670 |   |
| Rental                              |       | 137,002                                    |       | 269,750                              |       | 509,175 |   | 938,852 |   |
| Other                               |       | 42,782                                     |       | 9,399                                |       | 152,317 |   | 39,485 |   |
|                                |       | 1,161,316                                  |       | 2,466,152                            |       | 4,513,734 |   | 6,321,007 |   |
| **Operating expenses:**             |       |                                       |       |                                 |       |   |   |   |   |
| Cost of sales                       |       | 865,232                                    |       | 1,403,546                            |       | 2,714,857 |   | 3,566,691 |   |
| Selling, general and administrative |       | 1,581,271                                  |       | 1,267,831                            |       | 4,459,217 |   | 4,303,496 |   |
| Research and development            |       | 289,498                                    |       | 336,910                              |       | 961,058 |   | 709,770 |   |
| Inventory write down                |       | 575,446                                    |       | —                               |       | 575,446 |   | — |   |
|                                |       | 3,311,447                                  |       | 3,008,287                            |       | 8,710,578 |   | 8,579,957 |   |
| Loss from operations                |       | (2,150,131                                 | )          | (542,135                             | )          | (4,196,844 | ) | (2,258,950 | ) |
|                                |       |                                       |       |                                 |       |   |   |   |   |
| Interest expense, unrelated parties |       | 188,261                                    |       | 620,569                              |       | 682,362 |   | 1,709,430 |   |
| Interest expense, related parties   |       | 9,460                                      |       | 139,256                              |       | 24,523 |   | 413,559 |   |
| Gain on disposition of assets       |       | —                                     |       | —                               |       | (567 | ) | — |   |
|                                |       | 197,721                                    |       | 759,825                              |       | 706,318 |   | 2,122,989 |   |
|                                |       |                                       |       |                                 |       |   |   |   |   |
| Net loss                            |       | $                                          | (2,347,852 | )                                    | $          | (1,301,960 | ) | $ | (4,903,162 | ) | $ | (4,381,939 | ) |
|                                |       |                                       |       |                                 |       |   |   |   |   |
| Basic and diluted loss per share    |       | $                                          | (0.14      | )                                    | $          | (0.17 | ) | $ | (0.29 | ) | $ | (0.57 | ) |
|                                |       |                                       |       |                                 |       |   |   |   |   |
| Weighted average shares outstanding |       | 17,198,198                                 |       | 7,646,430                            |       | 17,184,127 |   | 7,636,185 |   |

 

See accompanyingnotes to financial statements.

 

2

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**VENDINGDATA CORPORATION**

### **STATEMENTS OF CASH FLOWS**

### ** **

**(UNAUDITED)**

** **
| ** **                                          | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
|                                                |       |                                     |       |   |   |
| **Operating activities:**                           |       |                                     |       |   |   |
| Net cash used in operating activities               |       | $                                        | (8,563,226 | ) | $ | (8,897,624 | ) |
|                                                |       |                                     |       |   |   |
| **Investing activities:**                           |       |                                     |       |   |   |
| Acquisition of intangible assets                    |       | (4,900                                   | )          | (1,022,720 | ) |
| Acquisition of plant and equipment                  |       | (193,043                                 | )          | (635,990 | ) |
| Acquisition of equipment produced for rental        |       | —                                   |       | (9,500 | ) |
| Disposition of equipment produced for rental        |       | —                                   |       | 785,600 |   |
| Other                                               |       | 665                                      |       | 705 |   |
| Deposits                                            |       | —                                   |       | (204,794 | ) |
| Net cash used in investing activities               |       | (197,278                                 | )          | (1,086,699 | ) |
|                                                |       |                                     |       |   |   |
| **Financing activities:**                           |       |                                     |       |   |   |
| Proceeds from sale of stock                         |       | —                                   |       | 574,420 |   |
| Reimbursement of offering expense                   |       | 36,731                                   |       | — |   |
| Proceeds from leases payable                        |       | —                                   |       | 989,820 |   |
| Repayment of leases payable                         |       | (1,731,966                               | )          | (2,110,205 | ) |
| Proceeds from notes payable                         |       | 3,250,000                                |       | 400,000 |   |
| Repayment of short-term debt                        |       | (32,493                                  | )          | (384,000 | ) |
| Proceeds from convertible debt                      |       | —                                   |       | 9,050,000 |   |
| Repayment of convertible debt                       |       | (1,603,077                               | )          | — |   |
| Net cash provided by (used in) financing activities |       | (80,805                                  | )          | 8,520,035 |   |
|                                                |       |                                     |       |   |   |
| **Change in cash and cash equivalents:**            |       |                                     |       |   |   |
| Decrease in cash                                    |       | (8,841,309                               | )          | (1,464,288 | ) |
| Cash and cash equivalents at beginning of period    |       | 11,526,664                               |       | 1,778,297 |   |
| Cash and cash equivalents at end of period          |       | $                                        | 2,685,355  |   | $ | 314,009 |   |

 

See accompanyingnotes to financial statements.

 

3

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**VENDINGDATA CORPORATION AND SUBSIDIARIES**

**NOTES** TO FINANCIAL STATEMENTS (UNAUDITED)

** **

**Note 1—Basis of Presentation**

 

The accompanying unaudited financial statements ofVendingData Corporation (the “Company”) have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions incorporated in Regulation S-B of the Securities andExchange Commission. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring adjustments and accruals) considered necessary for a fairpresentation have been included.

 

The results of operations for the periods presentedare not necessarily indicative of the results to be expected for the full year.The accompanying financial statements should be read in conjunction with theCompany’s audited financial statements for the year ended December 31,2003, as included in the Company’s Annual Report on Form 10-KSB as filedwith the Securities and Exchange Commission from which the accompanying balancesheet information as of that date was derived. Certain reclassifications havebeen made to amounts presented in prior periods for comparability to thecurrent period presentation.

 

**Note 2—Segments**

 

The revenue segments identified for geographicregion-based enterprise-wide data are as follows:  

 
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September, 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **    | ** ** | **2004**                             | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|          |       |                                 |       |                                 |       |   |   |   |   |
| United States |       | $                                    | 791,995    |                                 | $          | 1,856,432 |   | $ | 3,248,356 |   | $ | 5,636,287 |   |
| Asia          |       | 369,321                              |       | 461,250                              |       | 1,265,378 |   | 536,250 |   |
| South America |       | —                               |       | 148,470                              |       | — |   | 148,470 |   |
|               |            |                                      |            |                                      |            |  |  |  |  |  |  |  |  |

 

4

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TheCompany’s revenues, depreciation and operating income distribution by productare as follows:

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                |       |                                  |       |                                 |       |   |   |   |   |
| Revenues                            |       |                                  |       |                                 |       |   |   |   |   |
| SecureDrop®                    |       | $                                     | 106,637    |                                 | $          | 789,786 |   | $ | 385,412 |   | $ | 2,124,519 |   |
| Shuffler                            |       | 106,947                               |       | 670,409                              |       | 1,148,894 |   | 2,932,233 |   |
| Deck CheckerTM                  |       | 904,950                               |       | 996,558                              |       | 2,827,111 |   | 1,224,770 |   |
| Other revenue                       |       | 42,782                                |       | 9,399                                |       | 152,317 |   | 39,485 |   |
|                                |       | $                                     | 1,161,316  |                                 | $          | 2,466,152 |   | $ | 4,513,734 |   | $ | 6,321,007 |   |
| Depreciation and amortization       |       |                                  |       |                                 |       |   |   |   |   |
| SecureDrop®                    |       | $                                     | 0          |                                 | $          | 0 |   | $ | 0 |   | $ | 0 |   |
| Shuffler                            |       | 55,604                                |       | 141,252                              |       | 167,386 |   | 426,269 |   |
| Deck CheckerTM                  |       | 9,229                                 |       | 0                                    |       | 23,096 |   | 0 |   |
| Selling, general and administrative |       | 142,331                               |       | 136,250                              |       | 442,663 |   | 356,184 |   |
|                                |       | 207,164                               |       | 277,502                              |       | 633,145 |   | 782,453 |   |
| Operating income (loss)             |       |                                  |       |                                 |       |   |   |   |   |
| SecureDrop® gross margin       |       | $                                     | 61,691     |                                 | $          | 434,550 |   | $ | 172,068 |   | $ | 1,105,229 |   |
| Shuffler gross margin               |       | 12,702                                |       | 482,853                              |       | 827,094 |   | 2,146,459 |   |
| Deck CheckerTM gross margin     |       | 764,944                               |       | 742,381                              |       | 2,250,348 |   | 880,070 |   |
| Other cost of goods sold            |       | (1,118,699                            | )          | (597,178                             | )          | (2,026,079 | ) | (1,377,442 | ) |
| Selling, general and administrative |       | (1,581,271                            | )          | (1,267,831                           | )          | (4,459,217 | ) | (4,303,496 | ) |
| Research and development            |       | (289,498                              | )          | (336,910                             | )          | (961,058 | ) | (709,770 | ) |
|                                |       | $                                     | (2,150,131 | )                                    | $          | (542,135 | ) | $ | (4,196,844 | ) | $ | (2,258,950 | ) |

 

**Note 3—Loss per Share (Basic and Diluted)**

 

The basic loss per share is computed by dividing thenet loss for the period by the weighted average number of common sharesoutstanding for the period. Loss per share is unchanged on a diluted basissince the assumed exercise of common stock equivalents would have ananti-dilutive effect due to the existence of operating losses.

 

**Note 4—Debt**

 

The company retired $2,368,077of convertible debt during the nine months ended September 30, 2004 with cashpayments and conversions to common stock.

 

In the quarter endedSeptember 30, 2004, the Company borrowed $3,250,000 in the form of senior noteswith non-detachable warrants at a 9% interest rate.  Interest is to be paid semi-annually inarrears, and the principal is due August 15, 2007.

 

**Note 5—Options**

 

The Company currently has two stock option planspursuant to which it is authorized to issue options to purchase 3,000,000shares and 300,000 shares, respectively.  No stock-based employee compensation expensefor stock options was reflected in net income for years prior to 2003, as allstock options granted under those plans had an exercise price equal to orgreater than the fair market value of the underlying common stock on the dateof grant.  Stock-based compensationrecorded for the quarter 

 

5

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ended September 30, 2004 and for the nine monthsended September 30, 2004 was $30,081 and $44,752, respectively. There were atotal of 2,079,380 options outstanding as of September 30, 2004 with an exerciseprice range between $1.75 and $15.00 and a weighted average exercise price of$3.52.  All stock options have terms not exceeding 10 years.

 

**Note 6—****Liquidity Issues**

 

TheCompany’s ability to maintain adequate liquidity is dependent upon the successof management’s plans to address and overcome prior operating losses.  Management is updating its 2004 operatingplan to increase its sales by expanding its product line and improving itssales efforts both domestically and internationally.  Management has also adopted a program toreduce operating costs through the transfer of manufacturing operations toChina and restructuring its service functions to reduce labor and rentalexpense.  Management focused on financialcondition and liquidity improvements through its capital raising efforts in2003 along with substantial debt reduction and debt conversion.  Through the nine months ended September 30,2004, the Company remained reliant upon capital from external sources in orderto sustain its operations.  The Companybelieves that it has sufficient liquidity to support its operations until thefirst quarter of 2005 and that it will be able to secure additional debt orequity capital to meet its needs in 2005.  TheCompany’s efforts to secure additional financing sources are being impacted bythe outcome of the November 29, 2004 hearing on the preliminary injunctionsought by a competitor.  An adverseoutcome of that hearing would likely impact the cost of and availability ofadditional financing to the Company.  SeePart II - Other Information, Item 1. Legal Proceedings.

 

**Note 7—Trade Receivables From Major Customers**

 

As of and during the ninemonths ended September 30, 2004, approximately 2.7% of trade receivables and5.0 % of total sales and, as of and during the year ended December 31,2003, approximately 17.6% of trade receivables and 13.3% of total sales wereconcentrated in the Nevada gaming industry among five customers under commonownership. The Company’s future operations could be affected by adverse changesin the financial condition of, or the Company’s relationships with, thecommonly owned Nevada gaming customers, or economic, competitive and politicalconditions in our customers’ respective local areas or the gaming industry, ingeneral.

 

The Company manages itsconcentrations of credit risk by evaluating the creditworthiness of customersbefore credit is extended and monitoring it thereafter. The maximum losses thatthe Company would incur if a customer failed to pay amounts owed would belimited to the recorded receivables after any allowances provided.

 

**Note 8—Contingencies**

 

The Company is a party to certain claims, legalactions, and complaints, including a patent infringement action between theCompany and one of its main competitors. The Company cannot predict the likelyoutcome of any such litigation or whether any such substantial litigation wouldhave a material adverse effect on its business as presently conducted or asanticipated.

 

Inearly February 2004, the State of Nevada initiated a sales/use tax audit ofCentral Leasing and Madison Leasing, companies through which the Company hasobtained lease financing.  As of thisfiling the State of Nevada has not made a determination if there has been ashortfall in the payment of the sales/use tax. The Company has sold and leasedback shufflers and Deck CheckersTM over the last five years.  The auditor for the State of Nevada is tryingto determine at what level a sales/use tax needs to be collected.  The Company now collects from our customersin Nevada and remits payments to the State of Nevada.  If the State of Nevada determines that thesales of the products to the leasing companies is the 

 

6

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levelat which sales/use tax should have been collected, liability of the leasingcompanies would be passed to the Company. The amount of this potential liability could range from a refund of$230,000 to the payment of sales/use tax with interest and penalties of up to$500,000.  The Company intends to defendits position in this matter.

 

The Company iscurrently involved in litigation involving allegations that its productsinfringe upon the patents of a competitor. For additional information, see Part II – Other Information, Item 1.Legal Proceedings.

 

7

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## **Item2**. Management’s Discussion and Analysis or Plan of Operations.

## ** **

**Statement on Forward-LookingInformation**

 

Certaininformation included herein contains statements that may be consideredforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934, such asstatements relating to plans for product development, product placement,capital spending and financing sources. Such forward-looking information involves important risks anduncertainties that could significantly affect anticipated results in the futureand, accordingly, such results may differ from those expressed in anyforward-looking statements made herein. These risks, uncertainties and other factors include, but are notlimited to, those relating to our liquidity requirements, our ability to locatenecessary sources of capital to sustain our operations, the continued growth ofthe gaming industry, the success of our product development activities, theacceptance of our products in the marketplace, vigorous competition in thegaming industry, our dependence on existing management, changes in gaming lawsand regulations (including actions affecting licensing), our leverage and debtservice (including sensitivity to fluctuations in interest rates) and domesticor global economic conditions.

 

Foradditional discussion of the risks, uncertainties and other factors that mayadversely affect our operations, our product acceptance, our competitiveness inthe marketplace and our common stock, please see the section entitled, “RiskFactors,” in our Annual Report on Form 10-KSB, as filed with the Securities andExchange Commission on March 30, 2004.

 

### **Overview**

### ** **

Ourstrategy is to develop cost-effective niche products for the global gamingindustry.  We focus on products thatincrease the security, productivity and profitability of casinooperations.  Our strategy involvesmarketing certain of our products for sale or lease, depending on the product,the geographic location of the customer and other factors.  We rely on our internal sales staff anddistributor relationships for the sale and rental of our products.  Although we anticipate significant salesdevelopment and revenue growth, there is no assurance that we will generatesufficient revenue, cash flow or profit to sustain our operations.

 

During the nine monthsended September 30, 2004, we have focused on certain steps designed to improveour long-term operations and growth. These steps included the following:

 

•                                          Wetransferred the Deck CheckerTM technology from a third party vendor in Auckland,New Zealand to our China manufacturing facility.

 

•                                          Wesubstantially completed the development of our PokerOneTM shuffler and beganpreliminary prod0uction in our China facility beginning in May 2004.

 

•                                          Weleased and commenced operations in six additional buildings in our Chinafacility.

 

•                                          Wetransferred research and development for all our table game products to China.

 

•                                          Wecommenced the manufacture of our Deck CheckerTM in our China facility.

 

•                                          Wesubstantially completed the development of our new RandomPlusTM shuffler.

 

While we havefocused on these significant improvements, our sales have been adverselyimpacted by several factors, including:

 

•                                          Theeffect of pending corporate mergers of major gaming customers on theprogression of sales of our SecureDropTM products. 

 

•                                          Longerthan anticipated approval times from gaming regulatory labs for our DeckCheckerTM and PokerOneTM shuffler products.

 

•                                          Theamount of time and resources that have been spent to transfer significantcomponents of our operations to China.

 

•                                          Theperiods of redundant functions while the transfer of manufacturing andresearch/development to China has been underway.

 

•                                          Delaysin completion of our RandomPlusTM shuffler.

 

•                                          Thedevelopment of two additional specialty games for the Macau market which wasthe beta site for our PokerOneTM shuffler.

 

8

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**Financial Condition**

 

Totalassets decreased from $24,160,178 to $18,503,654between December 31, 2003 and September 30, 2004, a decrease of $5,656,524 or23.4%.  The decrease in total assets was due primarily to the$8,841,309 decrease in cash, offset, in part, by a $1,571,384 increase ininventories, a $1,509,522 increase in trade accounts receivable and a $339,630increase in prepaid expenses.  Thedecrease in cash was due to continuing negative operating cash flows and debtreduction.  The primary reason for the increase in trade receivables were the sale of Deck CheckersTM onextended payment terms.  Through the useof cash to increase our inventories of Deck CheckerTM units and shufflers,including the PokerOneTM Shuffler, we recognized a net$1,571,384 increase ininventories betweenDecember 31, 2003 andSeptember 30, 2004.  The netincrease in inventories includes a reserve of $575,446for obsolete inventories recorded during the three months ended September 30, 2004.  The increased reserve related primarily toour inventories of the Random Ejection ShufflerTM and SecureDrop® systems.

 

Totalliabilities decreased by $1,703,627, or 17.2%, from $9,914,953 to $8,211,326 between December 31, 2003 and September 30, 2004.  The decrease in total liabilities was dueprimarily to a $375,376 decrease in the current portion of our leases payable,a $617,858 decrease in our accounts payable, the elimination of our short-termdebt of $2,368,077 through repayment and conversions into common stock and a$1,356,590 decrease in the non-current portion of our leases payable, offset,in part, by the issuance of long-term notes in the original principal amount of$3,250,000.  The decrease in our accountspayable betweenDecember 31, 2003 andSeptember 30, 2004 was due primarily due to the final $500,000 payment forthe intellectual property rights for the Deck CheckerTM and the payment ofcertain outstanding payables with funds received from the public offering inDecember of 2003.  The decreases in ourleases payable, both current and non-current, was due to the repayment of debtowed on certain equipment leases.

 

Duringthe three months ended September 30, 2004, our management conducted a review ofour inventory and determined that there is some impairment of our inventory ofRandom Ejection ShufflersTM held for rental purposes, as well as related laborand overhead held in inventory. Additionally, our management determined that our inventory containedcertain obsolete parts related to the SecureDrop® Hard Count System.  In view of these findings, our managementestablished a reserve in the amount of $575,446, which was recorded as a chargeto cost of goods sold during the three months ended September 30, 2004.  Upon commencement of sales of the RandomPlusTMShuffler, Our management will review our Random Ejection ShufflerTM inventoryand believes that there is a possibility that additional reserves estimated tobe in the range between $700,000 and $1,200,000, may be required.  The provisioning of reserves for obsolete inventorywill be based primarily on our estimated forecast of product demand and relatedmanufacturing requirements.

 

### **Critical** Accounting Policies and Estimates

### ** **

Thefollowing is a summary of what our management believes are the critical accountingpolicies related to our operations.  Theapplication of these policies, in some cases, requires our management to makesubjective judgments regarding the effect of matters that are inherentlyuncertain.

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires our management to make estimates and assumptionsthat affect reported amounts and disclosures, some of which may requirerevision in future periods.  Actualresults could differ from these estimates. The following is a summary of what our management believes are thecritical accounting policies related to our operations.  The application of these policies, in somecases, requires our 

 

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managementto make subjective judgments and estimates regarding the effect of matters thatare inherently uncertain.

 

***Allowance for Doubtful Accounts.***

 

Inconnection with the preparation of our financial statements, management reviewsand evaluates the collectibility of our trade receivables and adjusts ourallowance for estimated uncollectible accounts as deemed necessary in thecircumstances.  These estimates have thepotential for critically affecting the determination of results of operationsfor any given period.  Factors consideredby management in making such estimates and adjustments include anyconcentrations among customers, changes in our relationships therewith, paymenthistory and the apparent financial condition thereof.

 

***Revenue Recognition.***

 

Werecognize revenue from the sale of our products upon installation andfunctional testing at customer locations because that is when the customer’sobligation becomes fixed and certain pursuant to our standard contracts for thesale of units of the SecureDrop® System, shufflers and Deck CheckersTM.  Sales are recognized immediately whenshufflers that are rented are converted to purchases depending on thecreditworthiness and payment history of the casino company since payment termsare from 20 to 48 months.  The extendedwarranty and maintenance components that are part of long term sales contractsare unbundled and recognized as deferred revenue amortized over the remaininglife of the sales agreement after the initial 90-day warranty as required bythe *Emerging Issues Task Force Issue No. 00-21, RevenueArrangements with Multiple Deliverables*.  The useful life of our shufflers and DeckCheckersTM is five years with proper maintenance; this life can be extended withthe replacement of component parts.  If acustomer does not possess the required creditworthiness or an establishedpayment history with us, we would then treat this revenue as an installmentsale and recognize the associated revenues over time as payments arereceived.  Revenue from shuffler rentalsis recorded at the first of each month in accordance with rental contractterms.  All rental contracts arecancelable upon 30-day written notice by the customer.  Maintenance expense for rental units isrecorded in the period it is incurred. Although sales are not generally made with a right to return, uponoccasion, usually associated with the performance warranty, sales returns andallowances are recorded after returned goods are received and inspected.  We provide currently for estimated warrantyrepair costs associated with sales contracts. Although there are no extended warranties offered for our products, wedo provide for maintenance contracts that are billed and recognized on amonthly basis.

 

***Intangible Assets.***

 

We haveacquired patent rights for various products since 2001 and acquired the patentrights for the Deck CheckerTM for $1,004,900 in the third quarter of 2003.  We have estimated an economic useful life of10 years for the Deck CheckerTM patents. We currently amortize our intangible assets which are related to thesepatents on a straight-line basis over the estimated useful lives of 10 years.

 

### **Results of Operations**

### ** **

##### ***Comparison ofThree Months Ended September 30, 2004 and 2003***

 

###### **Revenue**

###### ** **

Forthe three months ended September 30, 2004, total revenues decreased from$2,466,152 to $1,161,316, compared to the three months ended September 30,2003, a decrease of $1,304,836 or 52.9%. The decrease in total revenues was due primarily to decreases in ourSecureDrop® and our 

 

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shufflerrevenue.  We believe that the decreasesin revenue were due, in part, to the allocation of resources toward thetransfer of certain operations to China, the longer than anticipated approvalterms for our new products from gaming regulatory laboratories, the continueddevelopment and testing of our new shuffler products, the pending mergertransactions involving major U.S. casino operators that have delayednegotiations involving our SecureDrop® products and the delays in discussionswith potential international customers.

 

**Deck CheckerTM.**  Revenuerelated to the sale and rental of our Deck CheckerTM product decreased 9.2%compared to the three months ended September 30, 2003.  We expect Deck CheckerTM revenue to grow asthe number of jurisdictions where we can sell the product increases coupledwith increased industry acceptance of the product.

 

**SecureDrop®.**  OurSecureDrop® revenue decreased by 86.5% during the three months ended September30, 2004 in comparison to the three months ended September 30, 2003.  Although we currently have proposalsoutstanding for new contracts that may impact revenue in the fourth quarter of2004, due to the uncertainties related to the ultimate likelihood and timing ofthe award of these contracts, we believe that we will continue to experiencesignificant fluctuations in SecureDrop® revenue through the end of 2004 andinto 2005.

 

**Shufflers.**  During 2003,we made a strategic decision to offer our customers the choice to eithercontinue renting or to purchase our shufflers for the same monthly paymentsthrough long-term sales agreements that range from 24-48 months.  This decision was based on competitive forcesin the marketplace and the anticipated introduction of our next generationshufflers in 2004.  As result of thisstrategic decision, we recorded shuffler sale revenue in the three months endedSeptember 30, 2003 that we were not able to replace in the three months endedSeptember 30, 2004, resulting in a reduction in the number of shufflerscurrently outstanding on a rental basis. Accordingly, we experienced a 91.0% decrease in shuffler sales revenueand a 69.6% decrease in shuffler rental revenue during the three months endedSeptember 30, 2004 in comparison to the three months ended September 30,2003.  Furthermore, due to the continueddevelopment and testing of our new RandomPlusÔ andPokerOneTM shufflers, as well as delays in obtaining required regulatoryapprovals, we were also not able to replace either shuffler sales revenue orrental revenue with revenue from these new shuffler products during the threemonths ended September 30, 2004.

 

**Other Revenues.**  Our otherrevenues for the three months ended September 30, 2004 increased compared tothe three months ended September 30, 2003 due to increases in the sale ofsupplies for SecureDrop® and the Deck CheckerTM. The upward trend will continuefor these consumables as we increase the installed base, particularly DeckCheckerTM.

 

###### **Cost of Sales**

###### ** **

 For the three months ended September 30,2004, our cost of sales increased to $1,440,678,compared to $1,403,546 for the three months ended September 30, 2003, anincrease of $37,132 or 2.6%.  The cost ofsales for the threemonths ended September 30, 2004 includes a $575,446reserve for obsolete inventories.  Although our revenue during the threemonths ended September 30, 2004 decreased, our costs of sales during the threemonths ended September 30, 2004 increased primarily due to the aforementioned $575,446inventoryreserve.  The gross margin on revenue forthe three months ended September 30, 2004 was a negative $279,362, or anegative 24.1%. This comparesto a gross margin percentage of $1,062,606, or 43.1%, for the three monthsended September 30, 2003 and $990,640, or 48.1%, for the three months endedJune 30, 2004.  The decrease in grossmargin and gross margin percentage from the same period of the prior yearreflects the establishment of a $575,446 reservefor obsolete inventories,the sale of rented shufflers with low depreciated book values during the threemonths ended September 30, 2003, and the costs incurred during 2004 as wetransitioned our manufacturing from Las Vegas to China.  As this transition is completed, we expectimprovement in our gross margins in the remainder of 2004 and 2005.  However, as previously noted, management will

 

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continueto evaluate the transition of certain of our products, such as the RandomEjection ShufflerTM, which is anticipated to be replaced by the RandomPlusTMshuffler, to determine whether future periods should include additionalinventory reserves.

 

**Deck CheckerTM.**  The DeckCheckerTM cost of goods sold decreased by 114,171, or 44.9%, during the threemonths ended September 30, 2004.  Thedecrease was due primarily to a decrease in our Deck CheckerTM revenue.  The gross margin percentage on revenue fromDeck CheckerTM sales revenue was 84.5% during the three months ended September30, 2004, compared to 74.5% during the three months ended September 30,2003.  The increase in gross marginpercentage was due to the increased sale of Deck CheckersTM manufactured at ourChina facility during the three months ended September 30, 2004 versus the saleof Deck CheckersTM purchased from a third party manufacturer during the threemonths ended September 30, 2003.  Duringthe three months ended September 30, 2004, we sold the remaining Deck CheckersTMpurchased from this third party manufacturer. By manufacturing of Deck CheckersTM at our China facility, we anticipatelower costs per unit and an increase in gross margin percentage.

 

**SecureDrop®.**  Our SecureDrop®****cost of goods sold decreased by 87.3% during the quarterended September 30, 2004 .  The decreaseis directly related to the decrease in SecureDrop® sales during the sameperiod.  The gross margin percentage onrevenue from SecureDrop®****sales revenue was 57.9% in the threemonths ended September 30, 2004 compared to a gross margin percentage of55.0% for the three months ended September 30, 2003.

 

**Shufflers.**  Our shuffler****costof goods sold for the three months ended September 30, 2004 decreased by 94.5%compared to the three months ended September 30, 2003.  The decrease shuffler****cost ofgoods sold was due to the decreased sale of shuffler****units duringthe three months ended September 30, 2004. The gross margin percentage on revenue from shuffler****salesrevenue was 54.3% in the three months ended September 30, 2004 compared to89.8% for the three months ended September 30, 2003.  The conversion of existing rental shufflerswith low book values due to depreciation to purchases resulted in an increasedgross margin percentage during the three months ended September 30, 2003.

 

Thecost of sales and resultant gross margins cited above for the individualproducts described herein primarily include only material costs.  Associated direct labor and overhead expensesare reported only in aggregate and have not been allocated to individualproducts.  The allocation of such directlabor and overhead expenses to individual products would have the effect ofreducing the gross margin percentages for our products.

 

###### **Selling, General andAdministrative Expense**

###### ** **

Forthe three months ended September 30, 2004, our selling, general and administrativeexpenses were $1,581,271, an increase of $313,440, or 24.7%, from $1,267,831for the three months ended September 30, 2003. The increase in selling, general and administrative expenses relatedprimarily to increases in consulting and accounting expenses, travel andentertainment expenses, rents, legal and regulatory expenses and otherexpenses, offset, in part, by decreases in salaries and related costs as aresult of reductions in staff.   Includedin these expenses was a $293,383 increase in legal and regulatory expenses duethe increased investigatory and related gaming compliance costs, the increasedcosts associated with our financing activities, and the costs associated withour intellectual property litigation.

 

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###### **Research and DevelopmentExpense**

###### ** **

Forthe three months ended September 30, 2004, research and developmentexpenses were $289,498, a decrease of $47,412, or 14.1%, from $336,910 for thethree months ended September 30, 2003. The decrease in research and development expenses was due to the windingdown of development costs for the RandomPlusTM and PokerOneTM shufflers incurredin Las Vegas.  Although research anddevelopment has been a significant cost, we anticipate that these costs maydecrease in the future as a percentage of revenue as more of our research anddevelopment functions are being moved to our China facility.

 

**Interest Expense**

 

For the three monthsended September 30, 2004, we incurred interest expenses of $197,721, comparedto $759,825 for the three months ended September 30, 2003, a decrease of$562,104 or 74.0%.  This decrease was primarily attributable tothe reduced debt service as a result of a decrease in our outstandingindebtedness and the retirement and conversion of $20,331,995 convertible debtin December 2003 and during the three months ended March 31, 2004.

 

###### **Net Loss**

###### ** **

For the three months endedSeptember 30, 2004, we had a net loss of $2,347,852 compared to a net loss of$1,301,960 for the three months ended September 30, 2003, an increase of$1,045,892, or 80.3%.  The increase in net loss was primarilydue to decreases in revenue and increases in operating expenses, includinginventory reserves for obsolete inventory, offset, in part, by decreases ininterest expenses.  Basicloss per share was $0.14 for the three months ended September 30, 2004, compared to $0.17for the three months ended September 30, 2003.  Although we experienced increased lossesduring the three months ended September 30, 2004, the relative decrease inbasic loss per share for the three months ended September 30, 2004 was dueto the increased number of weighted average shares outstanding during the threemonths ended September 30, 2004 in light of our public offering of commonstock in December 2003 and the conversion of debt into shares of common stockin December 2003 and in the three months ended March 31, 2004.

 

##### ***Comparison of NineMonths Ended September 30, 2004 and 2003***

##### *** ***

###### **Revenue**

###### ** **

Forthe nine months ended September 30, 2004, our revenues were $4,513,734,compared to $6,321,007 for the nine months ended September 30, 2003, a decreaseof $1,807,273, or 28.6%.   The decreasewas due primarily to decreases in SecureDropTM revenue and shuffler revenue,offset, in part, by increases in Deck CheckerTM revenue.  We believe that the decreases in revenue weredue, in part, to the allocation of resources toward the transfer of certainoperations to China, the longer than anticipated approval times for our newproducts from gaming regulatory laboratories, the continued development andtesting of our new shuffler products, the pending merger transactions involvingU.S. major casino operators that have delayed negotiations involving ourSecureDrop® products and the delays in discussions with potential internationalcustomers.

 

**Deck CheckerTM.**  Revenuerelated to the sale and rental of our Deck CheckerTM product increased 115.5%for the nine months ended September 30, 2004 compared to the nine months endedSeptember 30, 2003.  The significantincrease in Deck CheckerTM revenue in 2004 was due to the introduction of theDeck CheckerTM  in the second quarter of2003.  We expect Deck CheckerTM revenue togrow as the number of jurisdictions where we can sell the product increasescoupled with increased industry acceptance of the product.

 

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**SecureDrop®.**  OurSecureDrop® revenue decreased by 81.9% during the nine months ended September30, 2004 in comparison to the nine months ended September 30, 2003.  The decrease was due to the major installationsof SecureDrop® products at properties operated by Caesars Entertainment Inc.during the nine months ended September 30, 2003 and the absence of sufficientsales to replace the revenue generated by these installations. Although we arecurrently have proposals outstanding for new contracts that may impact revenuein the fourth quarter of 2004, due to the uncertainties related to the ultimatelikelihood and timing of the award of these contracts, we believe that we willcontinue to experience significant fluctuations in SecureDrop® revenue throughthe end of 2004 and into 2005.

 

 **Shufflers.**  During 2003, we made a strategic decision tooffer our customers the choice to either continue renting or to purchase ourshufflers for the same monthly payments through long-term sales agreements thatrange from 24-48 months.  This decisionwas based on competitive forces in the marketplace and the anticipatedintroduction of our next generation shufflers in 2004.  As result of this strategic decision, werecorded shuffler sale revenue in the nine months ended September 30, 2003 thatwe were not able to replace in the nine months ended September 30, 2004 andreduced the number of shufflers placed on a rental basis.  Accordingly, we experienced a 59.2% decreasein shuffler sales revenue and a 62.2% decrease in shuffler rental revenueduring the nine months ended September 30, 2004 in comparison to the ninemonths ended September 30, 2003. Furthermore, due to the continued development and testing of our newRandomPlusÔ and PokerOneTM shufflers, as well asdelays in obtaining required regulatory approvals, we were also not able toreplace either shuffler sales revenue or rental revenue with revenue from thesenew shuffler products during the nine months ended September 30, 2004.

 

**Other Revenues.**  Our otherrevenues for the nine months ended September 30, 2004 increased compared to thenine months ended September 30, 2003 due to increases in the sale ofsupplies for SecureDrop® and the Deck CheckerTM. The upward trend will continuefor these consumables as we increase the installed base, particularly DeckCheckerTM.

 

###### **Cost of Sales**

###### ** **

Forthe nine months ended September 30, 2004, our cost of sales was $3,290,303,compared to $3,566,691 for the nine months ended September 30, 2003, a decreaseof $276,388, or 7.7%.  The cost of salesfor the nine months ended September 30, 2004 includes a $575,446 reservefor obsolete inventories recorded in the three months ended September 30, 2004.  Although our revenue during the three monthsended September 30, 2004 decreased significantly, our costs of sales during thethree months ended September 30, 2004 did not decrease proportionally primarilydue to the aforementioned $575,446 inventory reserve recorded during the threemonths ended September 30, 2004.  Thegross margin on revenue for the nine months ended September 30, 2004 was$1,223,431, or 27.1%, compared to the gross margin on revenue for the ninemonths ended September 30, 2003 of $2,754,316, or 43.6%.  The decrease in gross margin and gross marginpercentage from the nine months ended September 30, 2003 to the nine monthsended September 30, 2004 reflects a decrease in revenues and an increase incosts of sales during the period, including the $575,446 increase in inventoryreserves.  However, as previously noted,management will continue to evaluate the transition of certain of our products,such as the Random Ejection ShufflerTM, which is anticipated to be replaced bythe RandomPlusTM shuffler, to determine whether future periods should includeadditional inventory reserves.

 

**Deck CheckerTM.**  The DeckCheckerTM cost of goods sold increased by $232,693, or 67.5%.  The increase was due primarily to theincrease in Deck CheckerTM revenue during the nine months ended September 30,2004.  The gross margin percentage onrevenue from Deck CheckerTM revenue was 79.6% during the three months endedSeptember 30, 2004, compared to 71.9% during the three months ended

 

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September 30, 2003. The increase in gross margin percentage was due tothe increased sale of Deck CheckersTM manufactured at our China facility duringthe nine months ended September 30, 2004 versus the sale of Deck CheckersTMpurchased from a third party manufacturer during the nine months endedSeptember 30, 2003. During the nine months ended September 30, 2004, we soldthe remaining Deck CheckersTM purchased from this third party manufacturer. Bymanufacturing Deck CheckersTM at our China facility, we anticipate lower costsper unit and an increase in gross margin percentage.

 

**SecureDrop®.**   Our SecureDrop®****cost of goods sold decreased by 79.1% during the nine monthsended September 30, 2004.  The decreaseis directly related to the decrease in SecureDrop® revenue during the sameperiod.  The gross margin percentage onrevenue from SecureDrop®****sales revenue was 44.6% in the nine monthsended September 30, 2004 compared to a gross margin percentage of 52.0%for the nine months ended September 30, 2003.

 

**Shufflers.**  Our shuffler****costof goods sold for the nine months ended September 30, 2004 decreased by 61.1%compared to the nine months ended September 30, 2003.  The decrease in our shuffler****cost ofgoods sold was due to the decreased sale of shuffler****units duringthe nine months ended September 30, 2004. The gross margin percentage on revenue from shuffler****salesrevenue was 83.1% in the nine months ended September 30, 2004 compared to82.7% for the three months ended September 30, 2003.

 

Thecost of sales and resultant gross margins cited above for the individualproducts described herein primarily include only material costs.  Associated direct labor and overhead expensesare reported only in aggregate and have not been allocated to individualproducts.  The allocation of such directlabor and overhead expenses to individual products would have the effect ofreducing the gross margin percentages for our products.

 

###### **Selling, General andAdministrative Expenses**

###### ** **

Forthe nine months ended September 30, 2004, our selling, general andadministrative expenses were $4,459,217, compared to $4,303,496 for the ninemonths ended September 30, 2003, an increase of $155,721, or 3.6%.  The slight increase in selling, general andadministrative expenses related primarily to increases in consulting andaccounting expenses, trade show expenses, repairs and maintenance, legal andregulatory expenses, insurance costs, depreciation expense and finance fees,offset, in part, by decreases in advertising expenses, travel and entertainmentexpenses, supply costs and other expenses.

 

###### **Research and DevelopmentExpense**

###### ** **

For the nine months ended September 30, 2004, our research and development expenses were$961,058, compared to $709,770 for the nine months ended September 30,2003, an increase of $251,288, or35.4%.  The increase was due to expensesincurred as a result of our continued development efforts on the RandomPlusTM and PokerOneTM shufflers.

 

**Interest Expense**

 

For the nine months endedSeptember 30, 2004, we incurred interest expense of $706,885, compared to$2,122,989 for the nine months ended September 30, 2003, a decrease of$1,416,104 or 66.7%.  This decrease was primarily attributable tothe reduced debt service resulting from the substantial decrease in ouroutstanding indebtedness and the retirement and conversion into shares ofcommon stock of $20,331,995 convertible debt in December 2003 and in the threemonths ended March 31, 2004.

 

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###### **Net Loss**

###### ** **

Forthe nine months ended September 30, 2004, we had a net loss of $4,903,162,compared to a net loss of $4,381,939 for the nine months ended September 30,2003, an increase of $521,223, or 11.9%. The increase in net loss was primarily due to decreases in revenue andincreases in operating expenses, including inventory reserves for obsoleteinventory, offset, in part, by decreases in interest expenses.  Basic loss per share was $0.29 for the ninemonths ended September 30, 2004, compared to $0.57 for the nine months endedSeptember 30, 2003.  Although weexperienced increased losses during the nine months ended September 30, 2004, therelative decrease in basic loss per share for the nine months ended September30, 2004 was due to the increased number of weighted average shares outstandingduring the nine months ended September 30, 2004 in light of our public offeringof common stock in December 2003 and the conversion of debt into shares ofcommon stock in December 2003 and in the three months ended March 31, 2004.

 

### **LIQUIDITY AND CAPITAL RESOURCES**

### ** **

Becauseof our continued efforts to transition from a development stage company to anoperating company, we have generated substantial cash flow deficits fromoperations, including net cash used in operating activities of $8,563,226 and$8,897,624 for the nine months ended September 30, 2004 and 2003,respectively.  As a result, in order tofund our development and operating activities, we have historically relied uponcash from our financing activities, including $23,047,432 in net cash providedby our financing activities during the twelve months ended December 31,2003.  During the nine months endedSeptember 30, 2004, our operating activities used net cash of $8,563,226, ourinvesting activities used net cash of $197,278 and our financing activitiesused net cash of $80,805.  The net cashused in our financing activities consisted of the repayment of $3,367,536 inleases payable, short-term debt and convertible debt and proceeds of $3,250,000from a private placement of notes.

 

Due tothe net cash used in our operating activities, we have been substantiallydependent on cash from financing activities to fund our development andoperating activities.  We will continueto require cash from financing activities for our current operating needs untilour operations generate sufficient cash flow to provide for such cashrequirements.  Our management believesthat we will continue to be dependent upon our financing activities to sustainour operations in the near term.

 

###### **Sources of Capital**

###### ** **

Inaddition to our cash on hand and the cash to be generated from our operations,we anticipate relying upon private and institutional sources of debt andequity.  During the years ended December31, 2003 and 2002, our sources of capital included common stock offerings,equipment financing from a third party, short-term notes from stockholders,convertible debentures and other private sources of capital.

 

Withrespect to common stock offerings, we received proceeds of $25,415,504, $0 and$4,169,092 during the years ended December 31, 2003, 2002 and 2001,respectively.

 

Withrespect to equipment financing, we have sold and leased back most of ourfurniture, equipment, tooling and shufflers held for rent.  During the years ended December 31, 2003,2002 and 2001, we received proceeds of $989,820, $2,988,385 and $1,335,306,respectively, from equipment financing. During the years ended December 31, 2003, 2002 and 2001, we repaidequipment financing of $2,754,607, $2,823,331 and $1,824,118,respectively.  As of September 30,2004, we had outstanding equipment financing of $2,421,830.  These equipment leases have terms of 36 to 39months and were not recorded as sales because each of the leases included amandatory buy-back provision.

 

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Withrespect to short-term notes from stockholders, we received proceeds of$700,000, $2,264,871 and $4,029,402 during the years ended December 31, 2003,2002 and 2001, respectively.  Conversely,we repaid short-term notes from stockholders in the amounts of $1,310,000,$650,000 and $563,400 during the years ended December 31, 2003, 2002 and 2001,respectively.  As of September 30,2004, we had outstanding short-term loans in the aggregate amount of$238,250.  Prior to 2003, we weresubstantially dependent on short-term loans from our principal stockholder andother directors.  Despite such reliance,neither our principal stockholder nor our directors are obligated to provideadditional financing to us, and our principal stockholder and directors arefree to decline to fund additional financings to us at any time.  In such event and in the absence of otherthird party financing sources, we would most likely have substantial difficultyin raising additional financings.

 

Withrespect to convertible debentures, we received proceeds of $11,050,000,$4,903,076 and $0 from the placement of convertible debentures during the yearsended December 31, 2003, 2002 and 2001, respectively.  Conversely, we have repaid convertibledebentures in the amounts of $11,019,285, $0 and $0 during the years endedDecember 31, 2003, 2002 and 2001, respectively. We have completely retired the convertible debentures during the threemonths ended March 31, 2004.

 

###### **Outlook**

###### ** **

Ourability to maintain adequate liquidity is substantially dependent upon thesuccess of management’s plans to address and overcome prior operating losses.Management is updating its 2004 operating plan to increase our sales byexpanding our product line and improving our sales efforts both domesticallyand internationally.  Although we havecontinued to generate revenue from our products during the year ended December31, 2003 and the nine months ended September 30, 2004, we continue to strugglewith the placement of our products throughout the gaming industry.  We believe that certain  2004 potential sales that would havegenerated cash were delayed, in part, due to pending merger transactionsinvolving major U.S. casino operators that have delayed negotiations involvingour SecureDrop® products as well as delays in discussions with potentialinternational customers.  The degree ofmarket acceptance for our products will depend upon a variety of factors,including the effectiveness and reliability of our products, the continuedapprovals for our products from gaming jurisdictions, the success of ourmarketing and distribution strategies and the level of customer satisfaction.  In addition to our sales initiatives, ourmanagement has adopted efforts to reduce operating costs through the transferof manufacturing operations to China and restructuring our service functions.

 

Untilwe can generate sufficient cash from operations to support our business, wewill need to raise additional cash from private placements of debt or equity orfrom lease financing sources.** **In the event that such sources areinsufficient or unavailable, we will need to seek cash from public or privateplacements of debt or equity, institutional or other lending sources, sellcertain assets or change operating plans to accommodate such liquidityissues.  No assurances can be given thatwe will successfully obtain liquidity sources necessary to fund our operationsin the upcoming year.  If we continue togenerate significant losses from our operations and we are not able to locatedadditional sources of liquidity, we may be unable to continue as a goingconcern.  Through the nine months endedSeptember 30, 2004, we remained reliant upon capital from external sources inorder to sustain its operations.  Webelieve that we have sufficient liquidity to support our operations until thefirst quarter of 2005 and that we will be able to secure additional debt orequity capital to meet our needs in 2005.  Although at a cost higher thanother sources, we have access to up to $3,000,000 in lease financing as apotential source of liquidity should we need to draw on it.   Our efforts to secure additional financingsources are also being impacted by the outcome of the November 29, 2004 hearingon the preliminary injunction sought by a competitor.  An adverse outcome of that hearing wouldlikely impact the cost of and availability of additional financing to us.  See Part II — Other Information, Item 1.Legal Proceedings, below.

 

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## **ITEM3.**                             CONTROLS AND PROCEDURES

## ** **

*Evaluation of Disclosure Controls.* We evaluated the effectiveness of our disclosure controls and proceduresas of the end of the three months ended September 30, 2004.  This evaluation was done with theparticipation of Steven J. Blad, our chief executive officer, Douglas H.Caszatt, our acting chief financial officer, and Philip F. Otto, an independentconsultant retained by us in October 2004 to assist us in, among other things,reviewing our disclosure controls and procedures.  Disclosure controls and procedures arecontrols and other procedures that are designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed byus in the reports that we file under the Exchange Act is accumulated andcommunicated to our management, as appropriate to allow timely decisionsregarding required disclosure.

 

Ourmanagement does not expect that our disclosure controls and procedures or ourinternal controls over financial reporting will prevent all error and allfraud.  A control system, no matter howwell conceived and operated, can provide only reasonable, but not absolute,assurance that the objectives of a control system are met.  Further, any control system reflectslimitations on resources, and the benefits of a control system must beconsidered relative to its costs. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, have been detected.  These inherent limitations include therealities that judgments in decision-making can be faulty and that breakdownscan occur because of simple error or mistake. Additionally, controls can becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of a control.  The design of a control system is also basedupon certain assumptions about the likelihood of future events, there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions; over time, controls may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate.  Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and may not be detected.

 

Based on this evaluation, we concluded that, subjectto the limitations noted above, our disclosure controls and procedures areeffective to ensure that information we are required to disclose in reportsthat we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in the SEC’s rulesand forms.

 

*Changes inInternal Control Over Financial Reporting.*  Although there have been no significantchanges in internal controls or in other factors that could significantlyaffect these controls subsequent to the date of their evaluation, we arecontinuously evaluating means of enhancing our internal controls.  In this regard, in October 2004 we engagedPhilip F. Otto as an independent consultant to provide financial advisory andrelated services, including a review our financial systems, a review of ourcorporate governance procedures and the preparation of business plans,financial models, and presentations. Most recently, Mr. Otto has provided financial, strategic and merger andacquisition advisory services to technology companies. Mr. Otto has alsorecently served as Chief Financial Officer, Chief Executive Officer anddirector of MedioStream, Inc, managing its operations in both Silicon Valleyand Shanghai. From 1992 to1997, Mr. Otto was chairman and chief executiveofficer of NASDAQ-listed California Microwave, Inc.

 

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# **PART II** – OTHER INFORMATION

# ** **

## **ITEM 1.  LEGAL PROCEEDINGS**.

## ** **

OnMarch 27, 2002, Shuffle Master, Inc., or Shuffle Master, filed acomplaint (Case No. CV-S-02-0438-JCM-PAL) against VendingData in theUnited States District Court, District of Nevada.  The amended complaint alleges, among otherthings, claims for patent infringement and requests treble damages, aninjunction enjoining us from infringing on two of Shuffle Master’s patents, anaccounting of our gains and profits that resulted from the allegedinfringement, and for interest, costs and attorneys’ fees.  The Shuffle Master patents that are at issuein the litigation concern registering use of a playing card shuffler apparatusand the displaying of the use on a display. We have filed our answer, counterclaims, and amended counterclaimsagainst Shuffle Master.  In the answer,we deny Shuffle Master’s allegation of patent infringement and request thatShuffle Master’s complaint be dismissed. We also seek, in our amended counterclaim, a declaration that we do notinfringe Shuffle Master’s patents and that Shuffle Master’s patents and certainof its related claims are invalid.  Wefurther assert counterclaims against Shuffle Master for breach of contract andviolation of the Uniform Trade Secrets Act. On May 20, 2002, the United States District Court, District ofNevada denied Shuffle Master’s motion for preliminary injunction againstus.  Discovery in this litigation is nowclosed.  On May 28, 2003, we filed amotion for summary judgment.  The hearingon this motion for summary judgment was taken off calendar pending a rulingfrom the Court regarding claim construction to determine the scope anddefinition of the patent claims at issue. On March 31, 2004, the Magistrate Judge issued an order with regard toclaim interpretation, to which we have filed written objections.  On June 25, 2004, the District Court affirmedthe Magistrate Judge’s order.  On August24, 2004, we renewed our motion for summary judgment to invalidate ShuffleMaster’s patents, United States Patent Nos. 6,325,373 (“‘373”) and 6,068,258(“‘258”), which cover card moving mechanisms that regulate use of the shufflerapparatus.  On October 14, 2004, theDistrict Court issued an order denying the motion for summary judgment forfailure to submit admissible evidence in support of the motion for summaryjudgment.  We filed a motion forclarification and reconsideration of the Court’s order on November 5, 2004 inorder to have the underlying merits of our motion for summary judgmentconsidered.  No decision has yet beenreached on this motion.

 

OnOctober 5, 2004, Shuffle Master filed another patent infringement actionagainst us in the United States District Court, District of Nevada (CaseNo. CV-S-04-1373-JCM-LRL).  ShuffleMaster alleges that the use, importation and offering for sale of the PokerOneTMshuffler infringes Shuffle Master’s United States Patent No. 6,655,684.  On October 25, 2004, we filed our answer andcounterclaim that denies Shuffle Master’s allegations of patent infringementand requests that the Court enter a declaratory judgment ofnon-infringement.  The United StatesPatent and Trademark Office, on March 14, 2004, issued to us patent number490,481 for the PokerOneTM shuffler.  Weare offering the PokerOneTM for sale in the United States consistent with thepatent issued by the United States Patent and Trademark Office.  On October 14, 2004 Shuffle Master filed aMotion for Preliminary Injunction seeking to enjoin us from selling thePokerOneTM shuffler in the United States during the pendency of its secondlawsuit.  A court hearing on thepreliminary injunction request will be held on November 29, 2004.

 

## **ITEM 2.  CHANGES IN SECURITIES**.

## ** **

**CommonStock Offering. **On December 18, 2003, we completed apublic offering of 5,500,000 shares of our common stock.  The placement agent for the offering wasPhiladelphia Brokerage Corporation.  Ourshares of common stock sold in the offering were registered under theSecurities Act in a Registration Statement on Form SB-2, as amended (File No.333-109115), or the Registration Statement. The Securities and Exchange Commission declared the RegistrationStatement effective on December 11, 2003.

 

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Thepublic offering price was $5.00 per share for an aggregate sales price of$27,500,000.  We paid commissions of$1,925,000 to our placement agent, a non-accountable expense allowance of$25,000 to our placement agent and offering expenses of approximately $750,000.  None of the expenses related to the initialpublic offering were paid directly or indirectly to any of our directors,officers, general partners or their associates, or to any persons owning 10% ormore of any class of our equity securities, or to any of our affiliates.  We received net proceeds from the publicoffering of approximately $24,800,000 after deducting the underwritingdiscounts and commissions and the offering expenses.

 

Fromthe effective date of the Registration Statement through the nine months endedSeptember 30, 2004, we have used all of the $24,800,000 of net proceeds fromthe public offering as follows:

 

| **USE OF PROCEEDS TO DATE**                              | ** ** | **AMOUNT** | ** **     |
|----------------------------------------------------------|------------|------------|----------------|
| Retirement of  loan from Mellon Bank HBV SPV, LLC        |       | $          | 2,775,000      |   |
| Retirement of  loan from Triage Capital Management LP    |       | 850,000    |           |
| Retirement of loan from Triage Offshore Fund, Ltd.       |       | 1,000,000  |           |
| Retirement of loan from LC Capital Master Fund, Ltd.     |       | 1,000,000  |           |
| Retirement of a  portion of 10% convertible senior notes |       | 7,100,000  |           |
| Repayment of  convertible senior notes                   |       | 1,600,000  |           |
| Lease payments                                           |       | 1,200,000  |           |
| Funding to  increase product inventory                   |       | 1,500,000  |           |
| Purchase of  fixed assets                                |       | 160,000    |           |
| Payment of  operating expenses                           |       | 7,615,000  |           |
| **TOTAL**                                                | ** ** | **$**      | **24,800,000** | ** ** |

 

**DebtPrivate Placement. **On September 21, 2004, we received debtfinancing in the amount of $3,250,000 through a private placement of seniornotes and warrants.  PhiladelphiaBrokerage Corporation, the placement agent for the private placement, receiveda 4% commission totaling $130,000.  Theprivate placement consisted of units, where each unit consisted of a 9% seniornote in the original principal amount of $25,000 and a warrant to purchase1,500 shares of our common stock.  Wesold 130 units representing 9% senior notes in the original principal amount of$3,250,000 and warrants to purchase 195,000 shares of our common stock.  The warrants have an exercise price of $5.00per share and must be exercised before August 15, 2009.  The private placement terminated November 1,2004.

 

Theproposed uses for the private placement proceeds are for product build kits,tooling and manufacturing, product development and working capital.  The units were not registered pursuant to theSecurities Act but were offered pursuant to the exemption from registrationprovided by Rule 506 of Regulation D of the Securities Act.

 

## **ITEM 3.  DEFAULTS UPON SENIOR**SECURITIES.

## ** **

Notapplicable.

 

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## **ITEM 4.  SUBMISSION** OF MATTERS TO A VOTEOF SECURITY HOLDERS.

## ** **

OnOctober 5, 2004, we held our Annual Meeting of Stockholders at which thefollowing matters were voted on and approved by our stockholders:

 

1.             Election of four directors for terms expiringin 2005:

 
| ** **      | ** ** | **For**    | ** ** | **Against/Withheld** | ** ** |
|-----------------|------------|------------|------------|----------------------|------------|
|            |       |       |       |                 |       |
| Steven J. Blad  |       | 13,773,289 |       | 2,029,600            |       |
| James E. Crabbe |       | 15,703,489 |       | 99,400               |       |
| Ronald O. Keil  |       | 15,704,289 |       | 98,600               |       |
| Bob L. Smith    |       | 15,704,289 |       | 98,600               |       |

 

2.                                       Amendment to our 1999 Directors’ Stock OptionPlan increasing the number of shares reserved thereunder from 20,000 shares to300,000 shares: 

 

| For     |   | 11,110,877 |   |
|---------|--------|------------|--------|
| Against |   | 416,244    |   |
| Abstain |   | 12,814     |   |

 

3.                                       Amendment to our 1999 Stock Option Planincreasing the number of shares reserved thereunder from 2,000,000 shares to3,000,000 shares: 

 

| For     |   | 11,112,077 |   |
|---------|--------|------------|--------|
| Against |   | 424,444    |   |
| Abstain |   | 3,414      |   |

 

4.                                       Ratification of the appointment of PiercyBowler Taylor & Kern, as our independent auditors, for the fiscal yearending December 31, 2004:

 

| For     |   | 15,706,389 |   |
|---------|--------|------------|--------|
| Against |   | 91,500     |   |
| Abstain |   | 5,000      |   |

 

## **ITEM 5.  OTHER** INFORMATION.

## ** **

Notapplicable.

 

## **ITEM 6.  EXHIBITS** AND REPORTS ON FORM8-K.

## ** **

(a)           Exhibits.

 

10.1                           Form ofPromissory Note for 2004 Note Placement

 

10.2                           Form ofWarrant for 2004 Note Placement

 

10.3                           Form ofSecurity Agreement for 2004 Note Placement

 

31.1                           CertificationsPursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.2                           CertificationsPursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

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32.1                           Certificationof President and Chief Financial Officer Pursuant to Section 906 of theSarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).

 

(b)           Reportson Form 8-K.

 

Duringthe three months ended September 30, 2004, we filed the following:

 

•                                          Current Report on Form 8-K filed onAugust 9, 2004 reporting the issuance of a press release announcing ourfinancial results for the period ended June 30, 2004;

 

•                                          Current Report on Form 8-K filed onSeptember 22, 2004 disclosing materials provided at the Merriman Curhan FordInvestor Summit 2004 on Tuesday, September 21, 2004; and

 

•                                          Current Report on Form 8-K filed onSeptember 24, 2004 reporting the receipt of debt financing in the originalprincipal amount of $3,250,000 and the issuance of warrants to purchase anaggregate of 195,000 shares of our common stock.

 

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**SIGNATURE**

** **

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| ** ** | ** **        | **VENDINGDATA CORPORATION** |
|------------|-------------------|-----------------------------|
|       |              | (Registrant)                |
|       |              |                        |   |
| Date:      | November 15, 2004 | By:                         |  /s/ Steven J. Blad |   |
|       |              |                        |  Steven J. Blad |
|       |              | Its:                        |  Chief Executive Officer and President   (Principal Executive Officer and Duly   Authorized Officer) |

 

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