UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549









FORM 10-Q








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





For the Quarterly Period Ended June 30, 2010





OR





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




For the transition period from _____________________to______________________





Commission File Number: 000-51572


















PokerTek, Inc.


(Exact name of registrant as specified in its charter)





North Carolina

61-1455265(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)1150 Crews Road, Suite F, Matthews, North Carolina 28105(Address of principal executive offices) (Zip Code)(704) 849-0860(Registrant’s telephone number, including area code)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes x No o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes o No oh





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





oLarge accelerated filer

oAccelerated fileroNon-accelerated filer (do not check if a smaller reporting company)
xSmaller reporting company





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





As of August 6, 2010, there were 15,011,954 shares outstanding of the registrant’s common stock.












POKERTEK, INC.


TABLE OF CONTENTS










PagePART I – FINANCIAL INFORMATIONItem 1.
Financial Statements
1Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15Item 3.
Quantitative and Qualitative Disclosures about Market Risk
22Item 4.
Controls and Procedures
22PART II – OTHER INFORMATIONItem 5.
Other Information
22Item 6.
Exhibits
24Signatures
24Exhibit Index
25











POKERTEK, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)Three Months Ended June 30,


Six Months Ended June 30,2010


2009


2010


2009Revenue:Gaming

$
1,281,940


$
1,230,153


$
2,849,960


$
2,718,808Amusement


275,928



288,879



580,758



936,092Total revenue


1,557,868



1,519,032



3,430,718



3,654,900Cost of revenue:Gaming


513,300



766,231



1,140,951



1,534,515Amusement


1,229,177



246,381



1,532,029



832,553Total cost of revenue


1,742,477



1,012,612



2,672,980



2,367,068Gross profit


(184,609
)


506,420



757,738



1,287,832Operating Expenses:Selling, general and administrative


1,206,434



1,555,952



2,375,334



3,338,291Research and development


251,314



295,495



540,358



655,321Share-based compensation expense


149,497



111,131



373,596



369,377Depreciation


201,149



66,290



256,750



130,548Total operating expenses


1,808,394



2,028,868



3,546,038



4,493,537Operating loss


(1,993,003
)


(1,522,448
)


(2,788,300
)


(3,205,705
)Interest expense, net


(37,018
)


(96,564
)


(69,573
)


(181,271
)Net loss before income taxes


(2,030,021
)


(1,619,012
)


(2,857,873
)


(3,386,976
)Income tax provision


(9,866
)


(21,421
)


(38,607
)


(63,970
)Net loss

$
(2,039,887
)

$
(1,640,433
)

$
(2,896,480
)

$
(3,450,946
)Net loss per common share - basic and diluted

$
(0.14
)

$
(0.15
)

$
(0.20
)

$
(0.31
)Weighted average common shares outstanding - basic and diluted


14,627,645



11,021,429



14,350,435



11,021,429






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





1




POKERTEK, INC.CONSOLIDATED BALANCE SHEETSJune 30, 2010Assets

(Unaudited)


December 31, 2009Current assets:Cash and cash equivalents

$
704,280


$
636,374Accounts receivable, net


766,144



1,187,668Inventory


1,903,118



2,482,239Prepaid expenses and other assets


266,544



169,845Total current assets


3,640,086



4,476,126Other assets:PokerPro systems, net


2,124,233



2,408,161Heads-Up Challenge units, net


170,980



570,425Property and equipment, net


143,460



394,522Other assets


378,206



433,865Total assets

$
6,456,965


$
8,283,099Liabilities and Shareholders' EquityCurrent liabilities:Accounts payable

$
434,821


$
518,476Accrued liabilities


864,501



822,784Deferred revenue


434,301



495,767Long-term debt, current portion


24,099



26,239Total current liabilities


1,757,722



1,863,266Long-term liabilities:Deferred revenue


78,843



106,939Long-term liability - related party


396,500



-Long-term debt


801,722



812,396Total long-term liabilities


1,277,065



919,335Total liabilities


3,034,787



2,782,601Commitments and contingenciesShareholders' equity:Preferred stock, no par value per share; authorized 5,000,000, none issued and outstanding


-



-Common stock, no par value per share; authorized 100,000,000 shares, issued and outstanding 14,920,065 and 14,015,658 shares at June 30, 2010 and December 31, 2009, respectively


-



-Additional paid-in capital


46,318,332



45,500,172Accumulated deficit


(42,896,154
)


(39,999,674
)Total shareholders' equity


3,422,178



5,500,498Total liabilities and shareholders' equity

$
6,456,965


$
8,283,099






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





2




POKERTEK, INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY(unaudited)Common Stock


Additional


Accumulated


Total Shareholders'Shares


Value


Paid-in Capital


Deficit


EquityBalance, December 31, 2009


14,015,658


$
-


$
45,500,172


$
(39,999,674
)

$
5,500,498Share-based compensation


65,385



-



224,099



-



224,099Net loss


-



-



-



(856,593
)


(856,593
)Balance, March 31, 2010


14,081,043



-



45,724,271



(40,856,267
)


4,868,004Share-based compensation


65,385



-



149,497



-



149,497Issuances of common stock, net


773,637



-



444,564



-



444,564Net loss


-



-



-



(2,039,887
)


(2,039,887
)Balance, June 30, 2010


14,920,065


$
-


$
46,318,332


$
(42,896,154
)

$
3,422,178






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






3




POKERTEK, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)Six Months Ended June 30,2010


2009Cash flows from operating activities:Net loss

$
(2,896,480
)

$
(3,450,946
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


1,669,167



1,468,956Share-based compensation expense


373,596



369,377Provision for accounts and other receivables


30,958



26,705Changes in assets and liabilities:Accounts and other receivables


390,566



729,718Prepaid expenses and other assets


70,833



128,895Inventory


975,621



589,878PokerPro systems


(709,281
)


(307,753
)Heads-Up Challenge units


(19,763
)


-Accounts payable and accrued expenses


(41,938
)


(903,216
)Deferred revenue


(89,562
)


24,540Net cash used in operating activities


(246,283
)


(1,323,846
)Cash flows from investing activities:Purchases of property and equipment


(5,688
)


(49,449
)Sale of investments


-



3,900,000Net cash provided by (used in) investing activities


(5,688
)


3,850,551Cash flows from financing activities:Repayments of short-term debt


-



(2,865,357
)Proceeds from issuance of common stock, net


332,691



-Repayments of capital lease


(12,814
)


(11,674
)Net cash provided by (used in) financing activities


319,877



(2,877,031
)Net increase (decrease) in cash and cash equivalents


67,906



(350,326
)Cash and cash equivalents, beginning of period


636,374



1,481,530Cash and cash equivalents, end of period

$
704,280


$
1,131,204Supplemental Disclosure of Cash Flow InformationCash paid for:Interest

$
37,396


$
130,660Income taxes

$
49,510


$
45,086Non-cash transactions:Gaming inventory purchase - related party

$
396,500


$
-Issuance of common stock for commitment fee

$
112,750


$
-






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






4




POKERTEK, INC.


NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




Note 1.                      Nature of Business and Basis of Presentation




Nature of Business




PokerTek, Inc. (“PokerTek” or the “Company”) is engaged in the development, manufacture, and marketing of electronic poker-related products for use in the gaming and amusement markets.




The Company currently has two product lines, PokerPro® gaming products and Heads-Up ChallengeTM amusement products.




The PokerPro system consists of electronic poker table(s) and related peripheral equipment providing commercial casinos, tribal casinos, cruise ships and card clubs with a fully-automated poker-room environment designed to improve the profitability of poker by enhancing the operator’s revenue opportunities and decreasing startup and operating costs. Heads-Up Challenge (“HUC”) is an innovative amusement platform that enables two players to compete head to head against each other for entertainment purposes in non-gambling venues such as bars and restaurants.




Basis of Presentation and Significant Accounting Policies




The accompanying consolidated financial statements include the accounts of PokerTek, Inc. and its consolidated subsidiary. All significant intercompany transactions and accounts have been eliminated.




These consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Certain reclassifications have been made to prior periods’ financial information to conform to the current period presentation. There were no material changes during the most recent fiscal quarter in the Company’s significant accounting policies as described in the Annual Report.




The accompanying consolidated financial statements have been prepared without audit and are presented in accordance with Article 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States (“U.S. GAAP”) for annual financial statements. In the opinion of management, these consolidated financial statements include all adjustments, which consist only of normal recurring adjustments, necessary for a fair statement of the Company’s results of operations for the periods presented. The results of operations for the three and six months ended June 30, 2010 are not necessarily indicative of the results to be expected for the entire year.




Recent Accounting Pronouncements




In January 2010, the FASB issued an amendment to the fair value measurement and disclosure standard improving disclosures about fair value measurements. This amended guidance requires separate disclosure of significant transfers in and out of Levels 1 and 2 and the reasons for the transfers. The amended guidance also requires that in the Level 3 reconciliation, the information about purchases, sales, issuances, and settlements be disclosed separately on a gross basis rather than as one net number. The guidance for the Level 1 and 2 disclosures was adopted on January 1, 2010 and did not have an impact on the Company’s consolidated financial position, results of operations, or cash flows. The guidance for the activity in Level 3 disclosures is effective January 1, 2011 and will not have an impact on the Company’s consolidated financial position, results of operations or cash flows as the amended guidance provides only disclosure requirements. The Company had no transfers between Level 1, 2, or 3 inputs during the six months ended June 30, 2010.




In February 2010, the FASB issued amended guidance on subsequent events. Under this amended guidance, SEC filers are no longer required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. This guidance was effective immediately, and the Company adopted these new requirements for the quarter ended March 31, 2010.






5




Note 2.                      Operations and Liquidity Management.




Historically, the Company has incurred net losses and used cash from financing activities to fund its operations. Over the past several quarters, the Company reduced its operating expenses in order to improve its operating results and reduce its use of cash. As of June 30, 2010, the Company’s cash balance was approximately $0.7 million. Cash used in operations for the six months ended June 30, 2010 was approximately $(0.2) million. During the second quarter of 2010, the Company raised $360,000 with certain investors. See Note 10, “Shareholders’ Equity.” The level of additional cash needed to fund operations and the Company’s ability to conduct its business for the next year is influenced primarily by the following factors:




●
The pace of growth and the related spending on market penetration, regulatory efforts and related investments in inventory.




●
The successful transition to a heavier mix of recurring revenue, which generates less upfront cash compared to selling directly to an international distributor but still requires significant investments in inventory.




●
Management’s ability to control operating expenses and negotiate favorable payment terms with the Company’s customers and vendors as the business grows internationally and becomes more geographically diverse.




●
Management’s ability to access the capital markets and maintain availability under its credit line.




●
The impact of the economy or other factors on customers and suppliers, including the impact on demand for the Company’s products and customers’ ability to pay on a timely basis.




Management’s operating plan for 2010 is to balance revenue growth with operating expense control and working capital management while carefully monitoring the impact of growth on cash needs and cash balances. Should it become necessary, management plans to reduce expenditures related to inventory procurement and decrease variable operating expenses. In addition, management may also seek to raise additional capital or expand its credit facilities to bolster liquidity and to accelerate business growth during 2010.




Note 3.                      Inventory




Inventory at June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009Raw materials and components

$
1,340,133


$
2,141,139PokerPro systems in process


540,069



458,078Finished goods


383,755



241,858Reserve


(360,839
)


(358,836
)Inventory, net

$
1,903,118


$
2,482,239




Note 4.                      Prepaid Expenses and Other Assets




Prepaid expenses and other assets at June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009Prepaid expenses

$
109,343


$
103,053Stock issuance commitment fee, net


111,873



-Other


45,328



66,792Prepaid expenses and other assets

$
266,544


$
169,845Deferred licensing fees, net

$
324,444


$
364,482Other


53,762



69,383Other assets

$
378,206


$
433,865






6




Note 5.                      PokerPro Systems and Heads-Up Challenge Units




PokerPro systems and Heads-Up Challenge units at June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009PokerPro systems

$
7,854,683


$
7,831,243Less: accumulated depreciation and amortization


(5,730,450
)


(5,423,082
)PokerPro systems, net

$
2,124,233


$
2,408,161Heads-Up Challenge units

$
607,174


$
622,263Less: accumulated depreciation and amortization


(436,194
)


(51,838
)Heads-Up Challenge units, net

$
170,980


$
570,425




Note 6.                      Property and Equipment




Property and equipment at June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009Equipment

$
765,452


$
759,764Leasehold improvements


199,948



199,948Capitalized software


157,067



157,0671,122,467



1,116,779Less: accumulated depreciation


(979,007
)


(722,257
)Property and equipment, net

$
143,460


$
394,522




Capitalized software consists of purchased software, consulting and capitalized internal costs related to the purchase and the implementation of a new internal-use enterprise resource management system. Accumulated depreciation on capitalized software at June 30, 2010 was $87,201. The software portion of this systems investment was financed through a capital lease obligation. See Note 8, “Debt.”






7




Note 7.                      Accrued Liabilities




Accrued liabilities at June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009Professional fees

$
148,000


$
179,968Other liabilities and customer deposits


716,501



642,816Accrued liabilities

$
864,501


$
822,784




Note 8.                      Debt





The Company’s outstanding debt balances as of June 30, 2010 and December 31, 2009 consisted of the following:




June 30,


December 31,2010


2009SVB Credit Facility

$
-


$
-Founders' Loan


800,000



800,000Capital lease obligation


25,821



38,635Total debt


825,821



838,635Current portion of debt


24,099



26,239Long-term portion of debt

$
801,722


$
812,396




SVB Credit Facility: The Company maintains a credit facility with Silicon Valley Bank to support the Company’s working capital needs (the “SVB Credit Facility”). On July 23, 2009, the Company entered into amendments to the SVB Credit Facility, which extended the maturity date for the facility to July 23, 2010, adjusted the facility amount to have a Facility Limit of $2.5 million with maximum advances determined based on the composition of the Company’s eligible accounts receivable and inventory balances and modified certain other provisions of the facility.




Based on the Company’s accounts receivable and inventory levels on June 30, 2010, as of such date availability was approximately $1.0 million, with no borrowings outstanding. The SVB Credit Facility includes covenants requiring the achievement of specified financial ratios and thresholds and contains other terms and conditions customary for this type of credit facility. As of June 30, 2010, the Company was in compliance with these covenants. The SVB Credit Facility is collateralized by security interests in substantially all of the assets of the Company and is senior to the Founder’s Loan.




As of June 30, 2010, there were no amounts drawn under the SVB Credit Facility. The SVB Credit Facility has a one-year term and bears interest at an annual rate equal to the greater of prime plus 2.0% or 6.5%. In July 2010, the Company and SVB signed a letter of intent to extend the SVB Credit Facility through October 21, 2010 to provide additional time to finalize the terms of renewal.




Founders’ Loan:The Company entered into a loan agreement with Lyle A. Berman, James T. Crawford, Arthur L. Lomax and Gehrig H. White on March 24, 2008. Messrs. Crawford, Lomax and White are the founders of the Company. Each of the lenders is also a member of the board of directors, with Mr. Berman serving as Chairman and Mr. White serving as Vice Chairman. The $2.0 million loan originally called for cash interest at 13% with all unpaid principal and interest payable on March 24, 2010.




On July 9, 2009, the Founders’ Loan was amended to provide that monthly interest payments may be made, at the election of the holder, in common stock at a 13% annual interest rate pursuant to a formula or cash at a 9% annual interest rate. In addition, the maturity date of the loan was extended to March 21, 2012.




On September 10, 2009, the Company entered into an agreement with Lyle A. Berman, James T. Crawford, and Arthur L. Lomax to convert an aggregate $1.2 million principal amount of the loans into common stock.






8




The loan contains no restrictive covenants and, following the conversion described above, is collateralized by security interests in 62 PokerPro systems. Such interests have been subordinated to the SVB Credit Facility.




As of June 30, 2010, the carrying value of the Founders’ Loan was $0.8 million and its fair value was approximately $0.8 million.




Capital Lease Obligation: During 2008, the Company entered into capital lease obligations totaling $73,273 to finance the purchase of a new internal-use ERP system. These capital lease obligations bear interest at an annual rate of 9.4% and have a term of 36 months, resulting in monthly payments of $2,396. At the end of the lease term, the Company has the option to purchase the software for $101. The net book value of the assets under lease at June 30, 2010 was $69,866. Related depreciation expense recognized during the three and six months ended June 30, 2010 and June 30, 2009 was $13,089 and $26,178, respectively, resulting in accumulated depreciation of $87,201 at June 30, 2010.




Note 9.  Employee Benefit Plan




The Company has established a salary deferral plan under Section 401(k) of the Internal Revenue Code covering substantially all employees. The plan allows eligible employees to defer up to 15% of their annual compensation, subject to annual limitations established by the IRS. The Company matches the contributions equal to 100% on the first 3% of the deferral and 50% on the deferral from 3% to 5%. For the three months ended June 30, 2010 and June 30, 2009, the Company recorded contribution expense of $8,368 and $23,184, respectively. For the six months ended June 30, 2010 and June 30, 2009, the Company recorded contribution expense of $18,096 and $47,091, respectively.




Note 10.                       Shareholders’ Equity




Private Placement Transaction




During the quarter ended June 30, 2010, the Company and four officers and directors and five private investors entered into Subscription Agreements providing for the issuance by the Company and the purchase by the investors of a total of 536,137 shares of the Company’s common stock for an aggregate purchase price of $260,000 in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Section 4(6) and Regulation 506 under the Securities Act. The five private investors each received 10,000 common stock warrants at an exercise price of $1.00 for a total issuance of 50,000 common stock warrants.




Lincoln Park Transaction




On June 24, 2010, the Company signed a $5 million purchase agreement with Lincoln Park Capital Fund, LLC (“LPC”), an Illinois limited liability company.




Upon signing the agreement, LPC purchased 100,000 shares of common stock at a price of $1.00 per share and the Company received $100,000 in initial proceeds under the purchase agreement. The Company also issued a warrant to purchase an additional 100,000 shares of our common stock at an exercise price of $1.10 per share and containing a call provision exercisable by the Company in the event common shares trade above $3.00 per share for 20 consecutive days.




The Company entered into a registration rights agreement with LPC whereby the Company agreed to file a registration statement related to the transaction within 20 days with the U.S. Securities & Exchange Commission (“SEC”) covering the shares that have been issued or may be issued to LPC under the purchase agreement. After the SEC has declared effective the registration statement related to the transaction, the Company has the right over a 30-month period to sell shares of common stock to LPC every two business days in the amount of $50,000. This amount may be increased by $100,000 if the closing price of our shares is above $1.25, by $200,000 if the closing price is above $1.75, by $350,000 if the closing price is above $2.50 and by $500,000 if the closing price is above $3.75.




The purchase price of the shares related to the $4.9 million of future funding will be based on the prevailing market prices of the Company's shares at the time of sales without any fixed discount and subject to the floor price. The purchase price is determined based on the lesser of the lowest sale price on the purchase date or the average of the lowest three closing prices during the preceding 12 days.






9




In consideration for entering into the agreement, the Company issued to LPC 137,500 shares of our common stock. The Company shall issue up to 180,000 common shares on a pro rata basis only if and when the Company sell additional shares to LPC. These shares shall be held by LPC for 30 months or until such time as the Purchase Agreement is terminated




The Company will control the timing and amount of any future sales of shares to LPC and are under no obligation to sell any additional shares to LPC. The purchase agreement may be terminated by the Company at any time at its discretion and without any cost to it. Except for a limitation on variable priced financings, there are no negative covenants, restrictions on future funding, penalties or liquidated damages in the agreement. The proceeds received by us under the common stock purchase agreement are expected to be used for working capital purposes.




Stock Incentive Plan




Option activity under the Company’s stock incentive plans for the six months ended June 30, 2010 was as follows:




Weighted AverageShares


Exercise Price


Remaining Contractual

Term


Aggregate

Intrinsic ValueOutstanding at January 1, 2010


2,078,299


$
2.48



-



-Granted


312,000



0.64



-



-Exercised


-



-



-



-Forfeited


(102,100
)


5.51



-



-Expired


-



-



-



-Outstanding at June 30, 2010


2,288,199


$
2.11



8.6


$
(3,131,463
)Exercisable at June 30, 2010


641,779


$
4.67



7.0


$
(2,524,448
)




Note 11.  Income taxes




For the three months ended June 30, 2010 and June 30, 2009, the Company recognized a tax provision of $9,866 and $21,421, respectively. For the six months ended June 30, 2010 and June 30, 2009, the Company recognized a tax provision of $38,607and $63,970, respectively. These provisions are based principally on the Company’s estimated foreign income tax withholding liability, which is attributable to revenues generated outside of the United States.




The effective rates for the periods ending June 30, 2010 and 2009 differ from the U.S. federal statutory rate principally because: (1) the tax benefit arising from the Company’s net operating losses are fully offset by the valuation allowance established against the Company’s deferred tax assets: and (2) the Company incurs withholding taxes.




Note 12.  Related Party Transactions




Transactions with Aristocrat




License fees from and equipment sales to Aristocrat of $53,095 and $3,140, respectively, were recorded in the three months ended June 30, 2010, while $139,788 and $21,497, respectively, were recorded during the three months ended June 30, 2009. License fees from and equipment sales to Aristocrat of $120,819 and $3,140, respectively, were recorded in the six months ended June 30, 2010, while $313,452 and $102,025, respectively, were recorded during the six months ended June 30, 2009. As of June 30, 2010 and December 31, 2009, $35,043 and $150,448, respectively, were due from Aristocrat and included in accounts receivable in the accompanying Consolidated Balance Sheets. As of June 30, 2010 and December 31, 2009, $16,818 and $0, respectively, were due to Aristocrat and included in accounts payable in the accompanying Consolidated Balance Sheets.






10




The Company terminated its Exclusive Distribution Agreement and entered into an Equipment Purchase Arrangement with Aristocrat effective January 15, 2010. The Equipment Purchase Arrangement provides that the purchase price for the purchased equipment will be paid from the Company to Aristocrat as the purchased equipment is deployed and revenues are received by the Company. As revenues are received by the Company, the payment to Aristocrat will be calculated as 20% of the Company’s gross revenue attributable to each table, up to a specified cap per table. The Company has recorded a liability of $396,500 related to its purchase of inventory, which is reflected in long-term liabilities-related party on the accompanying Consolidate Balance Sheet as of June 30, 2010. No payments had been made to Aristocrat as of June 30, 2010.




The Company agreed to assume responsibility for (and take title to) certain PokerPro tables currently installed at specified customer locations. In return for transfer of these tables to the Company, the Company agreed to relieve Aristocrat of all responsibility and related costs to service, support, maintain, replace and repair those tables.




As of June 30, 2010 and December 31, 2009, Aristocrat owned 12.1% and 12.9%, respectively, of the Company’s common stock.




Transactions with ICP, Inc.




The Company purchased inventory and services from ICP, Inc. for the six month periods ended June 30, 2010 and June 30, 2009, of $283,914 and $239,125, respectively. As of June 30, 2010, $30,956 was due to ICP and included in accounts payable in the accompanying Consolidated Balance Sheets. As of June 30, 2010, the Company had purchase obligations with ICP, Inc. totaling $646,209. As of June 30, 2010 and December 31, 2009, ICP owned 4.6% and 4.9%, respectively, of the Company’s common stock. In August 2010, the Company amended its purchase commitment with ICP. See Note 15, “Subsequent Events.”




Office Lease




The Company leases its office and manufacturing facility under an annual operating lease from an entity owned and controlled by the Company’s President and the Company’s Vice Chairman of the Board of Directors. The lease expires in August 2011. Rent expense recorded for the leased space for the three months ended June 30, 2010 and June 30, 2009, was $42,600 and $48,800, respectively. Rent expense recorded for the leased space for the six months ended June 30, 2010 and June 30, 2009, was $85,200 and $103,700, respectively. This lease was amended as of June 1, 2009 with rent expense for the aggregate leased space adjusted to equal $14,200 per month.




Founders’ Loan




During the three months ended June 30, 2010 and June 30, 2009, the Company made $18,148 and $43,452, respectively, in aggregate interest payments in cash. During the six months ended June 30, 2010 and June 30, 2009, the Company made $35,901 and $107,561, respectively, in aggregate interest payments in cash. Refer to Note 8, “Debt,” for a description of the terms of this loan.




Note 13.  Segment Information




The Company reports segment information based on the “management approach.” The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.




The Company’s business is organized and reported in two segments, gaming and amusement, which are described in Note 1, Nature of Business and Significant Accounting Policies. The Company evaluates the performance of its two segments primarily based on revenues and gross margin. The accounting policies of the segments are the same as those described in the “Summary of Significant Accounting Policies.”






11




The following provides financial information concerning the reportable segments of the Company’s operations:




Gaming


Amusement



Corporate

and Other


TotalThree months ended June 30, 2010Revenue

$
1,281,940


$
275,928



$
-


$
1,557,868Cost of revenue


513,300



1,229,177

(1)


-



1,742,477Gross profit


768,640



(953,249
)
(1)


-



(184,609
)Depreciation and amortization


439,044



536,178

(1)


34,373



1,009,595Capital expenditures


-



-




1,423



1,423Six months ended June 30, 2010Revenue

$
2,849,960


$
580,758



$
-


$
3,430,718Cost of revenue


1,140,951



1,532,029

(1)


-



2,672,980Gross profit


1,709,009



(951,271
)
(1)


-



757,738Depreciation and amortization


993,209



602,253

(1)


73,705



1,669,167Capital expenditures


-



-




5,688



5,688Assets at June 30, 2010


4,699,730



705,302




1,051,933



6,456,965Three months ended June 30, 2009Revenue

$
1,230,153


$
288,879



$
-


$
1,519,032Cost of revenue


766,231



246,381




-



1,012,612Gross profit


463,922



42,498




-



506,420Depreciation and amortization


672,168



15,663




50,627



738,458Capital expenditures


-



37,738




1,518



39,256Six months ended June 30, 2009Revenue

$
2,718,808


$
936,092



$
-


$
3,654,900Cost of revenue


1,534,515



832,553




-



2,367,068Gross profit


1,184,293



103,539




-



1,287,832Depreciation and amortization


1,338,408



30,045




100,503



1,468,956Capital expenditures


-



37,738




11,711



49,449Assets at June 30, 2009


5,719,275



1,680,953




1,468,174



8,868,402






(1)
In the three and six months ended June 30, 2010, amounts presented in the column labeled “Amusement” include non-recurring charges of $905,054 in cost of revenue and gross profit and $150,507 in depreciation and amortization. See Note 15, “Subsequent Events.”




Amounts presented in the column labeled “Corporate and Other” primarily consist of assets that are not specifically associated with either segment, principally cash equivalents, investments and other corporate assets.






12




Revenues by Geographic Area




Revenues by geographic area are determined based on the location of the Company’s customers. For the three months ended June 30, 2010 and 2009, sales to customers outside the United States accounted for 38% and 21% of the Company’s consolidated revenue, respectively. For the six months ended June 30, 2010 and 2009, sales to customers outside the United States accounted for 40% and 35% of the Company’s consolidated revenue, respectively.




The following provides financial information concerning the Company’s revenues by geographic area:




Three months ended June 30,


Six months ended June 30,2010


2009


2010


2009Revenue:United States

$
972,952


$
1,200,948


$
2,063,747


$
2,377,269North America, excluding U.S.


317,398



156,186



910,116



611,454Europe


54,463



78,965



92,924



480,946Other International


213,055



82,933



363,931



185,231$
1,557,868


$
1,519,032


$
3,430,718


$
3,654,900




Note 14.                       Commitments and Contingencies




Legal Proceedings




The Company is subject to claims and assertions in the ordinary course of business. Legal matters are inherently unpredictable and the Company's assessments may change based on future unknown or unexpected events.




On August 21, 2009, a complaint was filed against the Company in the United States District Court for the District of Nevada by Marvin Roy Feldman. The plaintiff is seeking unspecified monetary damages related to the Company's distribution of PokerPro in Mexico. Prior to filing the complaint, the plaintiff provided correspondence to the Company requesting $250,000 or four PokerPro tables as compensation. While litigation is inherently unpredictable and subject to judicial and other risks beyond the Company’s control, the Company estimates the potential cost of this matter to range between $0 and $250,000. The Company believes that it has several meritorious defenses to these claims and intends to defend itself vigorously.




Note 15.                       Subsequent Events




On July 1, 2010, the Company received a letter from The NASDAQ Stock Market indicating that the closing bid price of its common stock had fallen below $1.00 for the 30 consecutive business days from May 19, 2010 to June 20, 2010, and therefore, the Company was not in compliance with NASDAQ Listing Rule 5550(a)(2) as of July 1, 2010.




NASDAQ provides an automatic 180 day grace period, through December 28, 2010, to regain compliance with the Bid Price Rule by maintaining a closing bid price of $1.00 per share for a minimum of 10 consecutive business days. At that time, if the Company has not regained compliance, the Company may receive a notice of delisting from NASDAQ, which is appealable to a hearing panel. Alternatively, the Company may at that time be eligible for an additional grace period of 180 days if it meets the initial listing standards, with the exception of bid price, for The NASDAQ Capital Market.




On August 5, 2010, the Company approved a plan to discontinue the operations of its Amusement segment. The operations of the Amusement segment will be reflected as a Discontinued Operation beginning with the September 30, 2010 reporting date.




The Company evaluated the trend of declining selling prices and margins in the first half of 2010 and determined the carrying value of the Amusement assets required adjustment to reflect those assets at the lower of cost or market based on estimated future cash flows. In addition, the Company’s obligations to purchase additional Amusement product was determined to be an unfavorable purchase commitment requiring recognition in the financial statements as of June 30, 2010. The Company plans to sell all of its Amusement product over the next year.




As a result, the Company recorded pre-tax charges of $1.1 million for the period ended June 30, 2010 which are included in income from operations.






13




The components of the $1.1 million charge as of June 30, 2010 are as follows:




Inventory - adjustment to lower of cost or market (1)

$
462,812Heads-Up Challenge Units – adjustment to lower of cost or market (1)


275,669Recognition of unfavorable purchase obligation and related costs (1)


166,573Property and Equipment  - Accelerated depreciation  (2)


150,507Total  charge

$
1,055,561






(1)
Included in cost of revenue (amusement) and gross profit in the Consolidated Statement of Operations for the three and six months ended June 30, 2010.




(2)
Included in depreciation in the Consolidated Statement of Operations for the three and six months ended June 30, 2010.




The Company does not expect to incur any other material transaction fees, severance costs, or other costs in connection with exiting the Amusement business.




Note 16.                      Unaudited Pro Forma Financial Information




The following unaudited pro forma information assumes that the disposition of the Amusement segment occurred as of January 1, 2009. The adjustments to the historical financial statements consist primarily of adjustments to exclude segment revenues, costs, assets and liabilities. This unaudited pro forma information should not be relied upon as necessarily being indicative of historical results that would have been obtained if the disposition had actually occurred on that date, nor of the results that may be obtained in the future.




The condensed consolidated pro forma statement of operations for the year ended December 31, 2009 is as follows:




As Reported


Adjustments


Pro formaRevenue

$
6,692,348


$
(1,278,526
)

$
5,413,822Gross profit


2,482,027



(83,656
)


2,398,371Operating expenses


7,760,417



(114,421
)


7,645,996Operating loss


(5,278,390
)


30,765



(5,247,625
)Net loss


(5,674,211
)


30,765



(5,643,446
)Net loss per common share - basic and diluted


(0.47
)


0.00



(0.47
)




The condensed consolidated pro forma statement of operations for the six months ended June 30, 2010 is as follows:




As Reported


Adjustments


Pro formaRevenue

$
3,430,718


$
(580,758
)

$
2,849,960Gross profit


757,738



951,271



1,709,009Operating expenses


3,546,038



(183,045
)


3,362,993Operating loss


(2,788,300
)


1,134,316



(1,653,984
)Net loss


(2,896,480
)


1,134,316



(1,762,164
)Net loss per common share - basic and diluted


(0.20
)


0.08



(0.12
)







14





The condensed consolidated pro forma balance sheet as of June 30, 2010 is as follows:




Assets

As Reported


Adjustments


Pro formaCurrent assets:Cash and cash equivalents

$
704,280


$
-


$
704,280Accounts receivable, net


766,144



(25,002
)


741,142Inventory


1,903,118



(506,806
)


1,396,312Other assets


266,544



(2,514
)


264,030Net assets - discontinued operations


-



705,302



705,302Total current assets


3,640,086



170,980



3,811,066Other assets:PokerPro systems, net


2,124,233



-



2,124,233Other assets


692,646



(170,980
)


521,666Total assets

$
6,456,965


$
-


$
6,456,965Liabilities and Shareholders' EquityCurrent liabilities:Accrued liabilities

$
864,501


$
(250,894
)

$
613,607Other liabilities


893,221



(49,719
)


843,502Net liabilities - discontinued operations


-



356,789



356,789Total current liabilities


1,757,722



56,176



1,813,898Long-term liabilities:Long-term debt


801,722



-



801,722Other liabilities


475,343



(56,176
)


419,167Total long-term liabilities


1,277,065



(56,176
)


1,220,889Total liabilities


3,034,787



-



3,034,787Total shareholders' equity


3,422,178



-



3,422,178Total liabilities and shareholders' equity

$
6,456,965


$
-


$
6,456,965






Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations




Forward-Looking Statements




This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Statements expressing expectations regarding our future (including pending gaming and patent approvals) and projections relating to products, sales, revenues and earnings are typical of such forward-looking statements and are made under the Private Securities Litigation Reform Act of 1995 (the “1995 Act”). The 1995 Act provides a “safe harbor” for forward-looking statements to encourage companies to provide information without fear of litigation so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected. Examples of forward-looking statements that we use include, but are not limited to, statements about our plans, objectives, representations and contentions and are not historical facts and typically are identified by use of terms such as "may," "will," "should," "could," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," "continue" and similar words, although some forward-looking statements are expressed differently.




All forward-looking statements are subject to the risks and uncertainties inherent in predicting the future. Meaningful factors that could cause actual results to differ materially from those projected include, but are not limited to, overall industry environment, customer acceptance of our products, delay in the introduction of new products, further approvals of regulatory authorities, adverse court rulings and litigation costs, production and/or quality control problems, the denial, suspension or revocation of permits or licenses by regulatory or governmental authorities, termination or non-renewal of customer contracts, amendment or termination of our loans, disruption of our relationships with our suppliers, competitive pressures, general economic and political conditions, such as political instability, credit market uncertainty, inflationary pressures, the rate of economic growth or decline in our principal geographic markets, each of which may be amplified by recent disruptions in the U.S. and global financial markets, our ability to access the capital markets, our exposure to foreign currency and operational complexities associated with foreign operations, and our financial condition. These and other risks and uncertainties are described in more detail in our most recent Annual Report on Form 10-K, as well as other reports and statements that we file with the Securities and Exchange Commission.






15




Forward-looking statements speak only as of the date they are made and should not be relied upon as representing our views as of any subsequent date. We undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur, except as required by applicable laws, and you are urged to review and consider disclosures that we make in this and other reports that we file with the Securities and Exchange Commission that discuss factors germane to our business.




Overview




We are engaged in the development, manufacture and marketing of electronic software and hardware products and we operate in two business segments – gaming and amusement. Through our gaming business, we currently market our PokerPro® product to casinos, cruise line operators, racinos, card clubs, and lotteries worldwide. Through our amusement business, we market our Heads-Up ChallengeTM product to coin-op amusement operators, distributors, bars, and restaurants.




During 2009, we made significant changes to our marketing plans and business strategies for both operating segments. We also initiated expense reductions in all aspects of our operations to improve our financial performance.




For PokerPro, we revised the marketing strategy to target markets with less competition from manual poker rather than highly competitive traditional gaming markets with large concentrations of poker tables. Those markets with less competition and more favorable conditions for electronic table games include cruise ships, racinos, international markets, and certain other geographic areas where manual poker is not prevalent or not allowed. In connection with this transition, we increased our focus on penetrating international gaming markets, including Canada, Mexico, and Europe. We terminated Aristocrat’s exclusive distribution agreement in January 2010 and are beginning to market our products on a direct basis worldwide. We believe this will allow us to focus more of our marketing and sales efforts on those markets that offer the best opportunity to build a strong recurring revenue business.




For Heads-Up Challenge, we transitioned from selling exclusively through distributors to placing product on a recurring license basis directly to operators and bars in the United States. We continued to sell the product in international markets and in certain other circumstances in the United States. The market for amusement products continues to be challenging and our revenues and gross margins have been steadily declining. In light of the deteriorating performance of the segment during the first half of 2010, the outlook for the Amusement industry and the significant decline in demand and pricing power for its Heads-Up Challenge, in August 2010 we approved a plan to discontinue our amusement business to focus on our higher-margin gaming business.




We recognized $1.1 million in non-recurring charges to reflect our amusement assets at net realizable value and to reflect an unfavorable purchase commitment. Excluding the non-recurring charges from the amusement business, results from our continuing gaming operations improved as a result of higher margins on the recurring revenues and lower operating expenses.




We are committed to increasing our penetration in our new target markets, continuing to control our spending and expect our financial results for 2010 to continue to improve as we execute our strategic plan. However, we have limited financial resources and our ability to raise capital on favorable terms is not known and may impact our ability to grow and to fully implement our strategic plans. We also expect economic sluggishness and tight credit markets to continue during 2010, which may impact revenues from existing customers as well as our ability to attract new customers. Changes in consumer confidence and spending and/or significant changes in the gaming and amusement markets or our ability to obtain financing could have a material impact on our future consolidated financial position, results of operations or cash flows.




Results of Operations for the Three Months Ended June 30, 2010 Compared to the Three Months Ended June 30, 2009




Revenues. Revenues increased by $38,836 (3%) to $1.6 million for the three months ended June 30, 2010 as compared to $1.5 million for the three months ended June 30, 2009.






16




Gaming revenue increased by $51,787 (4%) to $1.3 million for the three months ended June 30, 2010 as compared to $1.2 million for the three months ended June 30, 2009. Amusement revenue decreased by $12,951 (4%) to $275,928 for the three months ended June 30, 2010 as compared to $288,879 for the three months ended June 30, 2009. Gaming revenues were relatively flat, however the mix of revenues shifted as we moved gaming tables from traditional gaming markets in the United States to international markets with less competition.




Gross Profit. Gross profit was negative $184,609 for the three months ended June 30, 2010 and $506,420 for the three months ended June 30, 2009, a decrease of 136%. The decline in gross profit was attributable to the non-recurring charges incurred in our Amusement segment. Gross profit from the Gaming business improved 66% to $768,640 (60% margin) from $463,922 (38% margin) benefitting from reduced depreciation on leased assets.




Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) decreased by $0.4 million (22%) to $1.2 million for the three months ended June 30, 2010 as compared to $1.6 million for the three months ended June 30, 2009. This decrease was primarily due to lower salaries and other employee-related expenses as a result of the headcount reductions and other cost reduction initiatives. As a percentage of total revenues, SG&A expenses were 77% of total revenues for the three months ended June 30, 2010, compared with 102% of total revenues for the comparable period in 2009. Excluding the Amusement business, SG&A is 94% and 126% of Gaming revenue for the three months ended June 30, 2010 and 2009, respectively.




Research and Development Expenses. Research and development expenses decreased by $44,181 (15%) to $251,314 for the three months ended June 30, 2010 as compared to $295,495 for the three months ended June 30, 2009. We continue to invest in software and hardware development to improve PokerPro and to develop our new ProCore platform. However, our cost reduction initiatives favorably impacted research and development expenses.




Depreciation.Depreciation increased by $134,859 (203%) for the three months ended June 30, 2010 to $201,149 from $66,290 for the comparable period in 2009. The increase in depreciation was primarily attributable to acceleration of depreciation of tooling relating to the disposition of the Amusement business. Excluding the Amusement business, depreciation decreased by $16,254 (32%) for the three months ended June 30, 2010 to $34,373 from $50,627 for the comparable period in 2009. The decrease in depreciation was due primarily to certain assets being fully depreciated.




Interest expense, net.Interest expense decreased $59,546 (62%) for the three months ended June 30, 2010 to $37,018 from $96,564 for the three months ended June 30, 2009. The decrease was primarily attributable to the reduction in the principal balance of our Founders’ Loan from $2.0 million at June 30, 2009 to $0.8 million at June 30, 2010, combined with lower interest rates. Interest expense for the three months ended June 30, 2010 was composed of the following items: Founders’ Loan interest of $17,951; loan origination and unused line fees associated with the credit line from Silicon Valley Bank totaling $18,426; and interest on our capital lease of $705.




Income Taxes.Income tax provision was $9,866 for the three months ended June 30, 2010 and $21,421 in the comparable period of 2009. The decrease in income tax provision was attributable to reduced withholdings from Canada directly attributable to a decrease in revenue from Canada.




Net Loss.Net loss for the three months ended June 30, 2010 was $2.0 million, an increase of $0.4 million (24%) from $1.6 million for the three months ended June 30, 2009. Net loss per share, basic and diluted, was $0.14 per share for the three months ended June 30, 2010, an improvement of $0.01 (7%) per share from $0.15 for the comparable period of 2009. The increase in net loss was directly attributable to the $1.1 million in Amusement segment charges.




Results of Operations for the Six Months Ended June 30, 2010 Compared to the Six Months Ended June 30, 2009




Revenues. Revenues decreased by $0.2 million (6%) to $3.4 million for the six months ended June 30, 2010 as compared to $3.7 million for the six months ended June 30, 2009.




Gaming revenue increased by $0.1 million (5%) to $2.9 million for the six months ended June 30, 2010 as compared to $2.7 million for the six months ended June 30, 2009. Amusement revenue decreased by $0.3 million (38%) to $0.6 million for the six months ended June 30, 2010 as compared to $0.9 million for the six months ended June 30, 2009. Gaming revenues were relatively flat, however the mix of revenues shifted as we moved gaming tables from traditional gaming markets in the United States to international markets with less competition.






17




Gross Profit. Gross profit was $0.8 million for the six months ended June 30, 2010 and $1.3 million for the six months ended June 30, 2009, a decrease of 41%. The decline in gross profit was attributable to the non-recurring charges incurred in our Amusement segment. Gross profit from the Gaming business improved to $1.7 million (60% margin) from $1.2 million (44% margin) benefitting from reduced depreciation on leased assets.




Selling, General and Administrative Expenses. SG&A decreased by $1.0 million (29%) to $2.4 million for the six months ended June 30, 2010 as compared to $3.3 million for the six months ended June 30, 2009. This decrease was primarily due to lower salaries and other employee-related expenses as a result of the headcount reductions and other cost reduction initiatives. As a percentage of total revenues, SG&A expenses were 69% of total revenues for the six months ended June 30, 2010, compared with 91% of total revenues for the comparable period in 2009. Excluding the Amusement business, SG&A is 83% and 123% of Gaming revenue for the six months ended June 30, 2010 and 2009, respectively.




Research and Development Expenses. Research and development expensesdecreased by $0.1 million (18%) to $0.5 million for the six months ended June 30, 2010 as compared to $0.7 for the six months ended June 30, 2009. We continue to invest in software and hardware development to improve PokerPro and to develop our new ProCore platform. However, our cost reduction initiatives favorably impacted research and development expenses.




Depreciation.Depreciation increased by $126,202 (97%) for the six months ended June 30, 2010 to $256,750 from $130,548 for the comparable period in 2009. The increase in depreciation was primarily attributable to acceleration of depreciation of tooling relating to the disposition of the Amusement business. Excluding the Amusement business, depreciation decreased by $26,798 (27%) for the six months ended June 30, 2010 to $73,705 from $100,503 for the comparable period in 2009. The decrease in depreciation was due primarily to certain assets being fully depreciated.




Interest Income (Expense), net.Interest expense decreased $111,698 (62%) for the six months ended June 30, 2010 to $69,573 from $181,271 for the six months ended June 30, 2009. The decrease was primarily attributable to the reduction in the principal balance of our Founders’ Loan from $2.0 million at June 30, 2009 to $0.8 million at June 30, 2010, combined with lower interest rates. Interest expense for the six months ended June 30, 2010 was composed of the following items: Founders’ Loan interest of $35,704; loan origination and unused line fees associated with the credit line from Silicon Valley Bank totaling $32,374; and interest on our capital lease of $1,560.




Income Taxes.Income tax provision was $38,607 for the six months ended June 30, 2010 and $63,970 for the comparable period of 2009. The decrease in income tax provision was attributable was attributable to reduced withholdings from Canada directly attributable to a decrease in revenue from Canada.




Net Loss.Net loss for the six months ended June 30, 2010 was $2.9 million, an improvement of $0.6 million (16%) from $3.5 million for the six months ended June 30, 2009. Net loss per share, basic and diluted, was $0.20 per share for the six months ended June 30, 2010, an improvement of $0.11 (35%) per share from $0. 31 for the comparable period of 2009. The decrease in net loss was attributable to our cost reduction initiatives partially offset by the $1.1 million in Amusement segment charges.




Liquidity and Capital Resources




We have incurred net operating losses since inception and operating expenses may continue to exceed revenues. We have typically funded our operating costs, research and development activities, working capital investments and capital expenditures associated with our growth strategy with proceeds from the issuances of our common stock, as well as through credit arrangements from financial institutions and a loan from certain members of our Board of Directors.






18




Discussion of Statement of Cash Flows




Six Months Ended June 30,2010


2009


ChangeNet cash used in operating activities

$
(246,283
)

$
(1,323,846
)

$
1,077,563Net cash provided by (used in) investing activities


(5,688
)


3,850,551



(3,856,239
)Net cash provided by (used in) financing activities


319,877



(2,877,031
)


3,196,908Net increase (decrease) in cash and cash equivalents


67,906



(350,326
)


418,232Cash and cash equivalents, beginning of year


636,374



1,481,530Cash and cash equivalents, end of period

$
704,280


$
1,131,204




For the six months ended June 30, 2010, net cash used in operating activities was $0.2 million, as compared to $1.3 million for the six months ended June 30, 2009, a decrease of $1.1 million. The improvement in cash used in operating activities was primarily due to the reduction in net loss and management of working capital spending.




Net cash used in investing activities was $5,688 for the six months ended June 30, 2010, compared to cash provided by investing activities of $3.9 million for the six months ended June 30, 2009. During 2010, net cash used in investing activities is attributable to minor capital expenditures. During 2009, net cash provided by investing activities was primarily investments and redemptions of our auction rate securities (“ARS”) portfolio.




Net cash provided by financing activities was $319,877 for the six months ended June 30, 2010 compared to net cash used in financing activities of $2.9 million for the six months ended June 30, 2009. During 2010, we entered into a private placement resulting in net proceeds of $260,000 and also entered into a Stock Purchase Agreement with Lincoln Park Capital Fund LLC (“LCP”) resulting in initial cash proceeds of $100,000 (see description below). The proceeds from issuances of common stock were partially offset by payments on capital lease obligations totaling $12,814. During 2009, we liquidated our UBS Credit Facility in connection with the sale of our ARS investment.




We have the ability to impact the timing and extent of our cash needs primarily by managing the pace of growth and managing our operating expenses. However, we also have significant contractual obligations and our ability to control both the timing and extent of the cash needs of the business is not unlimited, particularly in light of the current economic climate and the capital intensive nature of the PokerPro business. As we expand our international business, we may also incur additional import duties, taxes, legal, professional fees, overhead costs, and working capital needs that could impact our ability to grow and manage liquidity.




Our intent is to balance revenue growth with operating expense and working capital management, while carefully monitoring the impact of growth on our cash needs and cash balances. Accordingly, reductions in our working capital investments or declines in demand for our products or continued deterioration in general economic conditions could impact our ability to grow or to effectively manage our liquidity needs.




Based on our current capital structure and our anticipated growth plans, we may continue to explore various alternatives to fund our growth, which may include raising additional funds through public or private offerings of our securities, obtaining additional credit facilities, converting our debt, or seeking alternative sources of financing, which may or may not be available on favorable terms, if at all. If such sources of capital are not available, we may seek other avenues to fund the business, including sale/leaseback arrangements, transitioning our products from a capital intensive leasing strategy to a product sale strategy, seeking to sell our assets, or reducing our operations. If we decide to raise additional capital in the equity markets or take other actions, shareholders could incur significant dilution, or, if we are unable to raise capital, our ability to effectively operate our business could be impaired.




Stock Purchase Agreement with LPC




On June 24, 2010, we signed a $5 million purchase agreement with LPC, an Illinois limited liability company.






19




Upon signing the agreement, LPC purchased 100,000 shares of common stock at a price of $1.00 per share and we received $100,000 in initial proceeds under the purchase agreement. We also issued a warrant to purchase an additional 100,000 shares of our common stock at an exercise price of $1.10 per share and containing a call provision exercisable by us in the event common shares trade above $3.00 per share for 20 consecutive days.




We entered into a registration rights agreement with LPC whereby we agreed to file a registration statement related to the transaction within 20 days with the U.S. Securities & Exchange Commission (“SEC”) covering the shares that have been issued or may be issued to LPC under the purchase agreement. After the SEC has declared effective the registration statement related to the transaction, we has the right over a 30-month period to sell shares of common stock to LPC every two business days in the amount of $50,000. This amount may be increased by $100,000 if the closing price of our shares is above $1.25, by $200,000 if the closing price is above $1.75, by $350,000 if the closing price is above $2.50 and by $500,000 if the closing price is above $3.75.




The purchase price of the shares related to the $4.9 million of future funding will be based on the prevailing market prices of our shares at the time of sales without any fixed discount and subject to the floor price. The purchase price is determined based on the lesser of the lowest sale price on the purchase date or the average of the lowest three closing prices during the preceding 12 days.




In consideration for entering into the agreement, we issued to LPC 137,500 shares of our common stock. We shall issue up to 180,000 common shares on a pro rata basis only if and when we sell additional shares to LPC. These shares shall be held by LPC for 30 months or until such time as the Purchase Agreement is terminated.




We will control the timing and amount of any future sales of shares to LPC and are under no obligation to sell any additional shares to LPC. The purchase agreement may be terminated by us at any time at our discretion and without any cost to us. Except for a limitation on variable priced financings, there are no negative covenants, restrictions on future fundings, penalties or liquidated damages in the agreement. The proceeds received by us under the common stock purchase agreement are expected to be used for working capital purposes.




Contractual Obligations




The table below sets forth our known contractual obligations as of June 30, 2010:




Total


Less than

1 year


1 - 3 years


3 - 5 years


More than

5 yearsDebt obligations(1)

$
926,000


$
72,000


$
854,000


$
-


$
-Operating lease obligations(2)


214,400



190,000



24,400



-



-Capital lease obligations(3)


27,125



25,356



1,769



-



-Purchase obligations(4)


650,839



650,839



-



-



-Other long-term liabilities(5)


396,500



-



396,500



-



-Total

$
2,214,864


$
938,195


$
1,276,669


$
-


$
-




(1)
Represents the outstanding principal amount and interest on our Founder’s Loan.




(2)
Represents operating lease agreements for office and storage facilities and office equipment.




(3)
Represents outstanding principal and interest payable under capital lease obligations related to our purchase of internal-use ERP system.




(4)
Represents open purchase orders with our vendors, primarily purchase obligations for Heads-Up Challenge.




(5)
Represents purchase of gaming inventory from Aristocrat. See Item 5, “Other Information.”




Contractual obligations increased to $2.2 million as of June 30, 2010 from $2.1 million as of December 31, 2009 due principally to an increase related to the purchase of gaming inventory from Aristocrat partially offset by a decrease in the level of inventory purchase commitments and lease obligations.






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On August 5, 2010, we amended our agreement related to our purchase obligation for our amusement product which reduced our purchase obligations from $650,839 to $217,857.




Customer Dependence




As of June 30, 2010, five of our customers made up approximately 52% of our total revenues. The loss of any of these customers or changes in our relationship with them could have a material adverse effect on our business.




Critical Accounting Policies




We follow accounting principles generally accepted in the United States in preparing our financial statements, which require us to make certain estimates and apply judgments that affect our financial position and results of operations. We continually review our accounting policies and financial information disclosures. A summary of our significant accounting policies that require the use of estimates and judgments in preparing the financial statements was provided in our Annual Report on Form 10-K for the year ended December 31, 2009. During the six months ended June 30, 2010, there were no material changes to the accounting policies and assumptions previously disclosed.




Recent Accounting Pronouncements




In January 2010, the FASB issued an amendment to the fair value measurement and disclosure standard improving disclosures about fair value measurements. This amended guidance requires separate disclosure of significant transfers in and out of Levels 1 and 2 and the reasons for the transfers. The amended guidance also requires that in the Level 3 reconciliation, the information about purchases, sales, issuances and settlements be disclosed separately on a gross basis rather than as one net number. The guidance for the Level 1 and 2 disclosures was adopted on January 1, 2010, and did not have an impact on our consolidated financial position, results of operations or cash flows. The guidance for the activity in Level 3 disclosures is effective January 1, 2011, and will not have an impact on our consolidated financial position, results of operations or cash flows as the amended guidance provides only disclosure requirements. We had no transfers between Level 1, 2, or 3 inputs during the six months ended June 30, 2010.




In February 2010, the FASB issued amended guidance on subsequent events. Under this amended guidance, SEC filers are no longer required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. This guidance was effective immediately, and we adopted these new requirements for the quarter ended March 31, 2010.




Subsequent Events




On July 1, 2010, the we received a letter from The NASDAQ Stock Market indicating that the closing bid price of our common stock had fallen below $1.00 for the 30 consecutive business days from May 19, 2010 to June 20, 2010, and therefore, we were not in compliance with NASDAQ Listing Rule 5550(a)(2) as of July 1, 2010.




NASDAQ provides an automatic 180 day grace period, through December 28, 2010, to regain compliance with the Bid Price Rule by maintaining a closing bid price of $1.00 per share for a minimum of 10 consecutive business days. At that time, if we have not regained compliance, we may receive a notice of delisting from NASDAQ, which is appealable to a hearing panel. Alternatively, we may at that time be eligible for an additional grace period of 180 days if we meet the initial listing standards, with the exception of bid price, for The NASDAQ Capital Market.




On August 5, 2010, we approved a plan to discontinue the operations of our Amusement segment. The operations of the Amusement segment will be reflected as a Discontinued Operation beginning with the September 30, 2010 reporting date.




As of June 30, 2010, we evaluated the carrying value of its inventory, leased assets, tooling and purchase commitments in light of the deteriorating performance of the segment during the first half of 2010, the outlook for the Amusement industry and the significant decline in demand and pricing power for our Heads-Up Challenge product. As of that date, indicators of impairment existed that ultimately led us to implement a formal plan of disposition. As a result, we recorded a $1.1 million charge as of June 30, 2010 to reflect our assets at net realizable value and to reflect an unfavorable purchase commitment.






21




Off-Balance Sheet Arrangements




We have no off-balance sheet arrangements.




Item 3.  Quantitative and Qualitative Disclosures About Market Risk.





Reference is made to “Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk,” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. There have not been significant changes in our exposure to market risk since December 31, 2009.




Item 4.  Controls and Procedures.




Disclosure Controls and Procedures




We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.




As of June 30, 2010, an evaluation of the effectiveness of our disclosure controls and procedures was conducted under the supervision of, and reviewed by, our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that our disclosure controls and procedures were effective as of June 30, 2010 to enable us to record, process, summarize, and report in a timely manner the information that we are required to disclose in our Exchange Act reports and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.




Changes in Internal Control over Financial Reporting




We made changes to our internal controls during the fourth quarter of 2009 in connection with the implementation of the inventory, fixed asset, MRP and other modules of our new ERP system in order to address previously identified significant deficiencies in internal control. During the second quarter of 2010, we were continuing to formalize and test those new procedures and controls in connection with the transition to the new system and can provide no assurance that all significant deficiencies will be resolved by the new systems and controls. These significant deficiencies have been reported to our Audit Committee by our management and to our independent registered public accounting firm.




PART II – OTHER INFORMATION




Item 5.  Other Information.




Between March 29, 2010 and April 7, 2010, we entered into Subscription Agreements with four officers and directors and five private investors providing for our issuance and the investors’ purchase of a total of 536,137 shares of our common stock for an aggregate purchase price of $260,000 in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Section 4(6) and Regulation 506 under the Securities Act. We relied upon, among other things, representations from the investors that they were “accredited investors” within the meaning of Rule 501(a) under the Securities Act as the basis for the exemptions. The five private investors each received 10,000 common stock warrants at an exercise price of $1.00 for a total issuance of 50,000 common stock warrants.




On June 24, 2010, we signed a $5 million purchase agreement with Lincoln Park Capital Fund, LLC (“LPC”), an Illinois limited liability company.






22




Upon signing the agreement, LPC purchased 100,000 shares of common stock at a price of $1.00 per share and we received $100,000 in initial proceeds under the purchase agreement. We also issued a warrant to purchase an additional 100,000 shares of our common stock at an exercise price of $1.10 per share and containing a call provision exercisable by us in the event common shares trade above $3.00 per share for 20 consecutive days.




We entered into a registration rights agreement with LPC whereby we agreed to file a registration statement related to the transaction within 20 days with the U.S. Securities & Exchange Commission (“SEC”) covering the shares that have been issued or may be issued to LPC under the purchase agreement. After the SEC has declared effective the registration statement related to the transaction, we have the right over a 30-month period to sell shares of common stock to LPC every two business days in the amount of $50,000. This amount may be increased by $100,000 if the closing price of our shares is above $1.25, by $200,000 if the closing price is above $1.75, by $350,000 if the closing price is above $2.50 and by $500,000 if the closing price is above $3.75.




The purchase price of the shares related to the $4.9 million of future funding will be based on the prevailing market prices of our shares at the time of sales without any fixed discount and subject to the floor price. The purchase price is determined based on the lesser of the lowest sale price on the purchase date or the average of the lowest three closing prices during the preceding 12 days.




In consideration for entering into the agreement, we issued to LPC 137,500 shares of our common stock. We shall issue up to 180,000 common shares on a pro rata basis only if and when we sell additional shares to LPC. These shares shall be held by LPC for 30 months or until such time as the Purchase Agreement is terminated.




We will control the timing and amount of any future sales of shares to LPC and are under no obligation to sell any additional shares to LPC. The purchase agreement may be terminated by us at any time at our discretion and without any cost to us. Except for a limitation on variable priced financings, there are no negative covenants, restrictions on future funding, penalties or liquidated damages in the agreement. The proceeds received by us under the common stock purchase agreement are expected to be used for working capital purposes.






23




Item 6.  Exhibits.




Exhibit No.
Description10.1
Subscription Agreements relating to the sale of a total of 536,137 shares of our Common Stock.10.2
Warrants to purchase a total of 50,000 shares of our Common Stock.10.3
Common Stock Purchase Agreement, dated as of June 24, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference from Exhibit 10.1 to our Form 8-K filed on June 25, 2010).10.4
Registration Rights Agreement, dated as of June 24, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference from Exhibit 10.2 to our Form 8-K filed on June 25, 2010).10.5
Form of Warrant (incorporated by reference from Exhibit 10.3 to our Form 8-K filed on June 25, 2010).31.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.







SIGNATURES




Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.






POKERTEK, INC.Date: August 16, 2010
/s/ Mark D. RobersonChief Executive Officer and Chief Financial Officer

(Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer)







24










POKERTEK, INC.


EXHIBIT INDEX






Exhibit No.
Description10.1
Subscription Agreements relating to the sale of a total of 536,137 shares of our Common Stock.10.2
Warrants to purchase a total of 50,000 shares of our Common Stock.10.3
Common Stock Purchase Agreement, dated as of June 24, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference from Exhibit 10.1 to our Form 8-K filed on June 25, 2010).10.4
Registration Rights Agreement, dated as of June 24, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference from Exhibit 10.2 to our Form 8-K filed on June 25, 2010).10.5
Form of Warrant (incorporated by reference from Exhibit 10.3 to our Form 8-K filed on June 25, 2010).31.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.