**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON,D.C. 20549**

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FORM 10-Q
| **x**                                            | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------|---------------------------------------------------------------------------------------------------|
| **FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004** |
| **OR**                                           |
| **o**                                            | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**COMMISSIONFILE NO. 0-23928**

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PDS GAMING CORPORATION

(Exact name of Registrantas specified in its charter)

| **Minnesota**                                                    | **41-1605970**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  Jurisdiction of  Incorporation or Organization) | (I.R.S. Employer  Identification No.) |
| **6171 McLeod Drive, Las Vegas, Nevada 89120**                   |
| (Address of  Principal Executive Offices)                        |
| **(702) 736-0700**                                               |
| (Issuer’s Telephone  Number, Including Area Code)           |

 

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Indicate by check mark whetherthe Registrant (1) has filed all reports required to be filed by Section 13or 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 suchreports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes x  No o

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Act).   Yes o  No x

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelast practicable date:

|                               | **Class** | ** ** | ** ** | ** ** | **Outstanding as of August 2, 2004** | ** ** |
|-------------------------------|-----------|------------|------------|------------|-------------------------------------------|------------|
| Common Stock, $.01  par value |      | 3,812,222  |

 

 

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**PDS GAMINGCORPORATION AND SUBSIDIARIESINDEX**
|                                                               | **Page**                                                                                                 |
|---------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
| **PART I    FINANCIAL  INFORMATION** |                                                                                                     |
| Item 1.                                                       | Financial Statements:                                                                                    |   |
|                                                          | Consolidated  Balance Sheets—June 30, 2004 (Unaudited) and December 31, 2003              | 3 |
|                                                          | Consolidated  Statements of Income (Unaudited)—Three Months Ended June 30, 2004 and  2003 | 4 |
|                                                          | Consolidated  Statements of Income (Unaudited)—Six Months Ended June 30, 2004 and 2003         | 5 |
|                                                          | Consolidated  Statements of Cash Flows (Unaudited)—Six Months Ended June 30, 2004 and  2003    | 6 |
|                                                          | Notes to Consolidated Financial  Statements (Unaudited)                                                  | 7-8 |
| Item 2.                                                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              | 9-14 |
| Item 3.                                                       | Quantitative  and Qualitative Disclosures About Market Risk                                              | 15 |
| Item 4.                                                       | Controls and  Procedures                                                                                 | 15-16 |
| **PART II    OTHER  INFORMATION**    |                                                                                                     |
| Item 6.                                                       | Exhibits  and Reports on Form 8-K                                                                   | 17 |

 

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**PART I—OTHERINFORMATION**

**ITEM 1.   FINANCIALSTATEMENTS**

**PDS GAMING CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                         | ** ** | **June 30,  2004** | ** **  | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                         | ** ** | **(Unaudited)**         | ** **  | ** **                  | ** ** |
| **ASSETS:**                                                                                                        |       |                    |        |                        |       |
| Cash and cash equivalents                                                                                          |       | $                       | 784,000     |                        | $          | 2,042,000 |   |
| Restricted cash                                                                                                    |       | 4,182,000               |        | 10,886,000                  |       |
| Notes, accounts  and leases receivable, net of allowances                                                          |       | 38,509,000              |        | 21,798,000                  |       |
| Equipment under  operating leases, net                                                                             |       | 91,759,000              |        | 77,922,000                  |       |
| Equipment held  for sale or lease                                                                                  |       | 1,420,000               |        | 1,984,000                   |       |
| Other assets, net                                                                                                  |       | 8,744,000               |        | 9,201,000                   |       |
|                                                                                                               |       | $                       | 145,398,000 |                        | $          | 123,833,000 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY:**                                                                    |       |                    |        |                        |       |
| Equipment vendors payable                                                                                          |       | $                       | 5,146,000   |                        | $          | 21,767,000 |   |
| Accounts payable                                                                                                   |       | 306,000                 |        | 311,000                     |       |
| Customer deposits                                                                                                  |       | 5,491,000               |        | 4,678,000                   |       |
| Notes payable                                                                                                      |       | 111,374,000             |        | 77,643,000                  |       |
| Subordinated debt                                                                                                  |       | 9,511,000               |        | 5,562,000                   |       |
| Accrued expenses  and other                                                                                        |       | 4,401,000               |        | 5,056,000                   |       |
|                                                                                                               |       | 136,229,000             |        | 115,017,000                 |       |
| Stockholders’  equity:                                                                                        |       |                    |        |                        |       |
| Common stock, $.01 par value, 20,000,000 shares  authorized, 3,812,222 and 3,806,222 shares issued and outstanding |       | 38,000                  |        | 38,000                      |       |
| Additional paid-in capital                                                                                         |       | 11,828,000              |        | 11,819,000                  |       |
| Deficit                                                                                                            |       | (2,697,000              | )           | (3,041,000                  | )          |
|                                                                                                               |       | 9,169,000               |        | 8,816,000                   |       |
|                                                                                                               |       | $                       | 145,398,000 |                        | $          | 123,833,000 |   |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMETHREE MONTHS ENDED JUNE 30,(Unaudited)**
| ** **                                      | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-------------------------------------------------|------------|------------|------------|-----------|------------|
| **REVENUES:**                                   |       |       |       |      |       |
| Equipment sales and sales-type leases           |       | $          | 10,378,000 |      | $          | 1,594,000 |   |
| Operating lease rentals                         |       | 8,628,000  |       | 6,137,000 |       |
| Finance income                                  |       | 996,000    |       | 1,216,000 |       |
| Fee income                                      |       | 156,000    |       | 668,000   |       |
| Casino                                          |       |       |       | 226,000   |       |
|                                            |       | 20,158,000 |       | 9,841,000 |       |
| **COSTS AND EXPENSES:**                         |       |       |       |      |       |
| Equipment sales and sales-type leases           |       | 8,935,000  |       | 1,394,000 |       |
| Depreciation on leased equipment                |       | 5,621,000  |       | 4,390,000 |       |
| Interest                                        |       | 3,806,000  |       | 2,405,000 |       |
| Casino                                          |       | 45,000     |       | 331,000   |       |
| Selling, general and administrative             |       | 1,394,000  |       | 849,000   |       |
| Depreciation and amortization on other property |       | 49,000     |       | 187,000   |       |
|                                            |       | 19,850,000 |       | 9,556,000 |       |
| Income before  income taxes                     |       | 308,000    |       | 285,000   |       |
| Income taxes                                    |       | 122,000    |       | 103,000   |       |
| Net income                                      |       | $          | 186,000    |      | $          | 182,000 |   |
| Earnings per share—basic and diluted       |       | $          | 0.05       |      | $          | 0.05 |   |
| Weighted average  shares outstanding:           |       |       |       |      |       |
| Basic                                           |       | 3,812,000  |       | 3,804,000 |       |
| Diluted                                         |       | 3,821,000  |       | 3,805,000 |       |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMESIX MONTHS ENDED JUNE 30,(Unaudited)**
| ** **                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| **REVENUES:**                                   |       |       |       |       |       |
| Equipment sales and sales-type leases           |       | $          | 17,997,000 |       | $          | 3,499,000 |   |
| Operating lease rentals                         |       | 17,397,000 |       | 11,542,000 |       |
| Finance income                                  |       | 1,793,000  |       | 2,202,000  |       |
| Fee income                                      |       | 294,000    |       | 1,643,000  |       |
| Casino                                          |       | 25,000     |       | 389,000    |       |
|                                            |       | 37,506,000 |       | 19,275,000 |       |
| **COSTS AND EXPENSES:**                         |       |       |       |       |       |
| Equipment sales and sales-type leases           |       | 15,576,000 |       | 2,994,000  |       |
| Depreciation on leased equipment                |       | 11,529,000 |       | 8,165,000  |       |
| Interest                                        |       | 6,999,000  |       | 4,637,000  |       |
| Casino                                          |       | 285,000    |       | 642,000    |       |
| Selling, general and administrative             |       | 2,399,000  |       | 1,766,000  |       |
| Depreciation and amortization on other property |       | 145,000    |       | 379,000    |       |
|                                            |       | 36,933,000 |       | 18,583,000 |       |
| Income before  income taxes                     |       | 573,000    |       | 692,000    |       |
| Income taxes                                    |       | 229,000    |       | 249,000    |       |
| Net income                                      |       | $          | 344,000    |       | $          | 443,000 |   |
| Earnings per share—basic and diluted       |       | $          | 0.09       |       | $          | 0.12 |   |
| Weighted average  shares outstanding:           |       |       |       |       |       |
| Basic                                           |       | 3,810,000  |       | 3,803,000  |       |
| Diluted                                         |       | 3,819,000  |       | 3,804,000  |       |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSSIX MONTHS ENDED JUNE 30,(Unaudited)**
| ** **                                              | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **OPERATING ACTIVITIES:**                               |       |        |       |        |       |
| Net cash used in operating activities                   |       | $           | (7,088,000 | )           | $          | (1,706,000 | ) |
| **INVESTING  ACTIVITIES:**                              |       |        |       |        |       |
| Purchase of equipment for leasing                       |       | (38,630,000 | )          | (13,890,000 | )          |
| Decrease (increase) in restricted cash                  |       | 6,704,000   |       | (1,021,000  | )          |
| Proceeds from sale of equipment under operating  leases |       | 190,000     |       | 50,000      |       |
| Other                                                   |       | (49,000     | )          | (55,000     | )          |
| Net cash used in investing activities                   |       | (31,785,000 | )          | (14,916,000 | )          |
| **FINANCING  ACTIVITIES:**                              |       |        |       |        |       |
| Proceeds from borrowings                                |       | 91,528,000  |       | 32,162,000  |       |
| Proceeds from borrowings of subordinated debt           |       | 9,500,000   |       |        |       |
| Repayment of borrowings                                 |       | (57,860,000 | )          | (13,961,000 | )          |
| Repayment of subordinated debt                          |       | (5,562,000  | )          | (500,000    | )          |
| Proceeds from issuance of common stock                  |       | 9,000       |       | 5,000       |       |
| Net cash provided by financing activities               |       | 37,615,000  |       | 17,706,000  |       |
| **CHANGE  IN CASH AND CASH EQUIVALENTS:**               |       |        |       |        |       |
| Net increase (decrease) in cash and cash equivalents    |       | (1,258,000  | )          | 1,084,000   |       |
| Cash and cash equivalents at beginning of period        |       | 2,042,000   |       | 115,000     |       |
| Cash and cash  equivalents at end of period             |       | $           | 784,000    |        | $          | 1,199,000 |   |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

**1.**   BASIS OFPRESENTATION:

The accompanying unaudited interim consolidatedfinancial statements have been prepared in accordance with generally acceptedaccounting principles for interim financial information and the instructions toForm 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do notinclude all of the information and disclosures required by generally acceptedaccounting principles for annual financial statements. In the opinion ofmanagement, all adjustments (including normal recurring adjustments) considerednecessary for a fair presentation have been included. The results of operationsfor any interim period are not necessarily indicative of results for the fullyear. For further information, please refer to the consolidated financial statementsof PDS Gaming Corporation (the “Company”), and the related notes, includedwithin the Company’s Annual Report on Form 10-K for the fiscal year ended December 31,2003 (the “2003 Form 10-K”), previously filed with the Securities andExchange Commission, from which the balance sheet information at December 31,2003 was derived.

Certain amounts aspreviously reported have been reclassified to conform to the currentpresentation.

**2.   STOCKOPTION PLANS:**

TheCompany has two stock option plans, the 1993 Stock Option Plan and the 2002Stock Option Plan. The Company applies Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*,and related interpretations, in accounting for its stock option plans. Based onthe related circumstances, no compensation expense has been recognized for thestock option plans. The Company has adopted the disclosure-only provisions ofStatement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure*, an amendment of FASB Statement No. 123 (“SFAS No. 148”).Had compensation expense for the Company’s stock option plans been determinedbased on the fair value at the grant date for awards under these plans,consistent with the methodology prescribed under SFAS No. 148, the Company’snet income and earnings per share would have approximated the pro forma amountsindicated below:
| ** **                                                             | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30**                                             | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2004**                                           | ** ** | **       2003       ** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net  income                                                   |       | $                                                  | 186,000    |                                                                                         |       | $ | 182,000 |   |   | $ | 344,000 |   | $ | 443,000 |   |
| Reported earnings  per share—basic and diluted               |       | 0.05                                               |       |                                                                                         | 0.05       |   |   | 0.09 |   | 0.12 |   |
| Adjustment to  compensation expense for stock-based awards, net of tax |       | 12,000                                             |       |                                                                                         | 41,000     |   |   | 24,000 |   | 81,000 |   |
| Pro forma net  income                                                  |       | 174,000                                            |       |                                                                                         | 141,000    |   |   | 320,000 |   | 362,000 |   |
| Pro forma earnings per  share—basic and diluted                   |       | 0.05                                               |       |                                                                                         | 0.04       |   |   | 0.08 |   | 0.10 |   |
|                                                                        |            |                                                    |            |                                                                                              |            |  |  |  |  |  |  |  |  |  |  |

 

The weighted-average fairvalue of each stock option included in the preceding pro forma disclosures wasestimated using the Black-Scholes option-pricing model and is amortized overthe vesting period of the underlying options.

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**PDS GAMING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

**3.   NOTESPAYABLE**

Notespayable consist of the following:
| ** **                                                                                                                                                                                                    | ** ** | **June 30,  2004** | ** **  | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| Lines of credit  with a maximum aggregate balance of $15,697,000 bearing interest at rates  from 5.25% to 10.50%, secured by related investment in leases, equipment held  for sale or lease and other assets |       | $                       | 9,011,000   |                        | $          | 9,151,000 |   |
| Equipment notes bearing  interest at rates from 0% to 15.00%, secured by related investment in leases:                                                                                                        |       |                    |        |                        |       |
| Recourse                                                                                                                                                                                                      |       | 12,594,000              |        | 12,216,000                  |       |
| Non-recourse                                                                                                                                                                                                  |       | 90,361,000              |        | 56,978,000                  |       |
|                                                                                                                                                                                                          |       | 111,966,000             |        | 78,345,000                  |       |
| Unamortized loan  discounts                                                                                                                                                                                   |       | (592,000                | )           | (702,000                    | )          |
|                                                                                                                                                                                                          |       | $                       | 111,374,000 |                        | $          | 77,643,000 |   |

 

**4.   CONTINGENCY**

In February 2003, the Company announced that ithad entered into a letter of intent with respect to a proposal submitted by themanagement group consisting of Johan P. Finley, the Company’s Chairman andChief Executive Officer, Lona M.B. Finley, the Company’s Executive VicePresident, Secretary and Chief Administrative Officer, and Peter D. Cleary, theCompany’s President, Treasurer and Chief Financial Officer (collectively, the “ManagementGroup”), to acquire all of the approximately 69% of the outstanding shares ofthe Company’s common stock not already owned by the Management Group. In April 2004,the Company announced that it had entered into a definitive Agreement and Planof Merger (the “Plan”) with PDS Holding Co., LLC, an entity controlled by theManagement Group (“PDSH”) relating to the proposal of the Management Group, andthat its Board of Directors and the Special Committee of the Board, composed ofthe Company’s three independent directors, unanimously approved the Plan.

The consummation of the management buyout transactioncontemplated by the Plan is subject to the satisfaction of a number ofconditions, including, without limitation, approval of such transaction by amajority of the Company’s outstanding shares and by a majority of the Company’soutstanding shares not owned by the Management Group, the truthfulness of theCompany’s representations and warranties, the absence of a material breach ofthe Company’s and PDSH’s respective obligations, the exercise of dissenter’srights by less than 5% of the Company’s outstanding shares, the procuring ofall necessary consents of the Company’s commercial lenders and the securing ofrequired approvals from all gaming regulatory agencies.

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

**OVERVIEW**

The Company is engaged in the business of leasing andother financing of gaming equipment and remarketing previously leased gamingdevices to casino operators. The gaming equipment financed by the Companyconsists mainly of slot machines, video gaming machines and other gamingdevices. In addition, the Company finances furniture, fixtures and othergaming-related equipment, including gaming tables and chairs, restaurant andhotel furniture, vehicles, security and surveillance equipment, computers andother office equipment. The Company believes it is currently the onlyindependent leasing company licensed (or registered, as the case may be) in thestates of Nevada, New Jersey, California, Colorado, Illinois, Indiana, Iowa,Minnesota, Mississippi and New Mexico to provide this financing alternative. Inearly 2001, the Company received a nonrestricted gaming license from the NevadaGaming Commission to operate The Gambler, now known as Rocky’s Casino andSports Bar (“Rocky’s”), in Reno, Nevada. Due to continuing operating losses,the Company sought and was granted approval from the Nevada Gaming ControlBoard to temporarily cease operations at Rocky’s effective January 31,2004. Prior to that time, Rocky’s was licensed to operate 180 slot machines. TheCompany is evaluating its future alternatives for Rocky’s, which include sale,lease or joint venture of the property.

The Company’s quarterly operating results, includingnet income, have historically fluctuated due to the timing of completion oflarge financing transactions, as well as the timing of recognition of theresulting fee income upon subsequent sale. These transactions can be in thenegotiation and documentation stage for several months, and recognition of theresulting fee income by the Company may fluctuate greatly from quarter toquarter. Thus, the results of any quarter are not necessarily indicative of theresults that may be expected for any other period.

The Company’s operatingresults are also subject to quarterly fluctuations resulting from a variety ofother factors, including, but not limited to, (i) variations in the mix offinancing transactions between operating leases, notes receivable and leasesreceivable, (ii) changes in the gaming industry which affect the demandfor used gaming devices sold by the Company at lease termination, and (iii) economicconditions, in which a detrimental change can cause customers to delay newinvestments and increase the Company’s bad debt exposure, and reduce the levelof fee income obtained through the sale of leases or financing transactions.

**STRATEGY**

The Company’s strategy isto increase recurring revenues and cash flows through originations of leases. Inaddition to its leasing activities, the Company also originates notetransactions which it generally sells to third parties. In some of itstransactions, the Company holds the leases or notes for a period of time afterorigination or retains a partial ownership interest in the leases or notes. TheCompany believes its ability to remarket used gaming devices enhances thegaming devices’ values at the end of an operating lease and facilitatesadditional financing transactions.

**SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES**

The preparation of financial statements in conformitywith generally accepted accounting principles requires the Company’s managementto make estimates and assumptions that affect reported amounts and disclosures,some of which may require revision in future periods. The most significantestimates are those involving residual values, collectibility of notes,accounts and leases receivable and valuation of equipment held for sale orlease.

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Following is a summary of what management believes arethe critical accounting estimates and policies of the Company. The applicationof these policies, in some cases, requires the Company’s management to makesubjective judgments regarding the effect of matters that are inherentlyuncertain. See Note 1, “Summary of Significant Accounting Policies,” to theCompany’s Consolidated Financial Statements included within the Company’sAnnual Report on Form 10-K for the fiscal year ended December 31,2003, previously filed with the Securities and Exchange Commission, for a moredetailed discussion of the Company’s accounting policies.

**BalanceSheet Presentation.****  **TheCompany prepares its balance sheet in an unclassified format, as is customaryin its industry, because the working capital concept is not particularlymeaningful for its business.

**Revenueand Cost Recognition.  **The Company recordsrevenue primarily in accordance with SFAS No. 13*, Accountingfor Leases*,and SFAS No. 140,*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*, along with other related guidanceunder generally accepted accounting principles and other applicable regulatoryguidance.

The Company’sleasing activities include operating, direct finance and sales-type leases. Forall types of leases, the determination of profit considers the estimated valueof equipment at lease termination, referred to as the residual value. Theissues specific to operating, direct finance and sales-type leases are asfollows:

·       Foroperating leases, revenue and depreciation on the leased equipment are recordedon the straight-line method over the term of the lease.

·       Directfinance and sales-type leases are similar in that substantially all of thebenefits and risks of ownership of the leased equipment are transferred to thelessee, and finance income is recognized at a constant percentage return on theasset carrying value. The carrying value consists of the present value of thefuture lease payments plus any unguaranteed residual, sometimes referred toherein as leases receivable. A dealer’s profit or loss on the subject equipmentis recognized at the inception of a sales-type lease.

Estimates related to the economic life of theequipment and present value factors can influence the classification of a lease.The Company selects present value factors based upon perceived economic riskassociated with the transaction relative to alternatives. The economic life ofthe related equipment is generally determined by reference to industrypractices.

After the inception of a lease, the Company maydiscount or sell notes and future lease payments to reduce or recover itsinvestment in the asset. Initial direct costs related to leases and notesreceivable are capitalized as part of the related asset and amortized over theterm of the agreement using the interest method, except for operating leases,for which the straight-line method is used.

Equipment held for sale or lease, consisting primarilyof gaming devices, is valued at the lower of average unit cost or netrealizable value. Revenue is recognized when title transfers to the customerupon shipment of used gaming devices or upon the exercise of a purchase optionunder an operating lease.

**Allowances For Collectionand Other Losses.  **Allowances for losses aremaintained at levels determined by the Company’s management to adequatelyprovide for collection losses and any other-than-temporary declines in otherasset values. In determining estimated losses, the Company’s management considerseconomic conditions, the activity in used equipment markets, the effect ofactions by equipment manufacturers, the financial condition of customers, theexpected courses of action by lessees with regard to leased equipment attermination of the initial lease term, changes in technology and other factorswhich management believes are relevant. Recoverability of an asset value ismeasured by a comparison of the carrying amount of the asset to future net cashflows expected to be generated by the asset. If a loss is 

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indicated, the lossto be recognized is measured by the amount by which the carrying amount of theasset exceeds the estimated net realizable value of the asset. Assetcharge-offs are recorded upon the disposition of the underlying assets. Managementreviews the Company’s assets on a quarterly basis to determine the adequacy ofthe allowances for losses.

**RESULTS OF OPERATIONS**

**Three months ended June 30,2004 and 2003**

The Company reported net income of $186,000 or $0.05per diluted share in the second quarter 2004 compared to net income of $182,000or $0.05 per diluted share in the second quarter 2003. The Company completed$30.4 million in originations in the second quarter 2004 compared with $42.6million in the second quarter 2003. Originations in the second quarter 2004included $21.6 million sourced through two customers. Originations in thesecond quarter 2003 included $23.0 million sourced through a single customer. Includedin this amount was a $20.8 million note syndicated by the Company, of which$1.0 million was retained by the Company for its portfolio.

Total revenues and the mix of revenues and relatedcosts for the comparable periods varied significantly, but this variability isnot unusual given the nature of the Company’s operations. Revenues in thesecond quarter 2004 totaled $20.2 million compared to $9.8 million in theyear-earlier quarter, an increase of $10.4 million. This increase reflectshigher levels of revenues from equipment sales and sales-type leases andoperating lease rentals.

Revenuesfrom equipment sales and sales-type leases are summarized as follows:
| ** **                                                                                                                                     | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|
| Sales-type lease  revenues, representing sales of equipment at the inception of a lease in  which a dealer’s profit or loss is recognized |       | $                       | 9,652,000  |                    | $          | 85,000                   |       | $ | 9,567,000 |   |
| Sales of  equipment from inventory                                                                                                             |       | 596,000                 |       | 1,142,000               |       | (546,000                 | )          |
| Sales of  equipment coming off lease                                                                                                           |       |                    |       | 250,000                 |       | (250,000                 | )          |
| Retail sales of  gaming equipment and merchandise                                                                                              |       | 130,000                 |       | 117,000                 |       | 13,000                   |       |
|                                                                                                                                           |       | $                       | 10,378,000 |                    | $          | 1,594,000                |       | $ | 8,784,000 |   |

 

The increase in sales-type lease revenues of $9.6million is primarily the result of a lessee purchasing leased equipment, whichhad previously been under operating leases. The Company is financing the purchaseof the equipment by the customer via sales-type leases.

Costs of equipment sales and sales-type leases totaled$8.9 million and $1.4 million in the quarters ended June 30, 2004 and2003, respectively. The increase in costs corresponds to the increase inrevenues from equipment sales and sales-type leases. Changes in margin, whichwere 14% in the second quarter 2004 and 13% in the second quarter 2003, resultfrom a number of factors, including variations in supply and demand in themarkets served by the Company.

Rental revenues from operating leases increased by$2.5 million, or 41%, to $8.6 million in the second quarter 2004 from $6.1million in the year-earlier quarter as a result of the Company’s significantlylarger portfolio of operating leases, in relation to other leases, in thecurrent year. This portfolio increased to an average of $89.4 million in thesecond quarter 2004 from $55.7 million in the year-earlier period as aresult of the Company’s aggressive sales efforts. Related depreciation increasedto $5.6 million from $4.4 million for the quarters ended June 30, 2004 and2003, respectively.

Finance income primarily represents interest incomeearned from notes and leases receivable, and decreased by 18% to $1.0 millionin the second quarter 2004 from $1.2 million in the year-earlier quarter. 

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This decrease reflects thedeclining percentage of the Company’s new originations that have resulted innotes and leases receivable.

Fee income decreased by 77% to $156,000 in the secondquarter 2004 from $668,000 in the year-earlier quarter. Fee income hashistorically fluctuated due to the timing of completion of large financingtransactions, as well as the timing of the subsequent sale of notes and leasesreceivable.

Interest expense totaled $3.8 million in the secondquarter 2004 compared to $2.4 million in the second quarter 2003, an increaseof 58%. This increase results from higher average debt levels, resultingprimarily from new originations, and a higher weighted average cost of funds inthe second quarter 2004 compared to the second quarter 2003. The weightedaverage cost of funds, which includes the amortization of capitalized loancosts, increased to 13.2% in the second quarter 2004 from 12.1% in the secondquarter 2003 due to market factors.

Selling, general and administrative expenses increasedby 64% to $1.4 million in the second quarter 2004 from $849,000 in theyear-earlier quarter. Included in the increase of $545,000 is $320,000 in costsrelating to taking the Company private.

The estimated effectiveincome tax rate was 40% in the second quarter 2004 as compared to 36% in thesecond quarter 2003. In both periods, the estimated effective rate was higherthan the federal statutory tax rate of 34% due primarily to state income taxesand permanent tax differences.

**Six months ended June 30,2004 and 2003**

The Company reported net income of $344,000 or $0.09per diluted share for the six months ended June 30, 2004 compared to netincome of $443,000 or $0.12 per diluted share for the six months ended June 30,2003. The Company completed $59.4 million in originations in the six monthsended June 30, 2004 compared with $74.1 million in the six months ended June 30,2003. Originations in the current year included $46.1 million sourced throughthree customers. Originations in the prior year included $51.1 million sourcedthrough two customers.

Revenues in the six months ended June 30, 2004totaled $37.5 million compared to $19.3 million in the year-earlier period, anincrease of $18.2 million or 95%. This increase reflects higher levels ofrevenues from equipment sales and sales-type leases and operating leaserentals.

Revenuesfrom equipment sales and sales-type leases totaled $18.0 million in the sixmonths ended June 30, 2004 compared to $3.5 million in the year-earlierperiod, and are summarized as follows:
| ** **                                                                                                                                     | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|
| Sales-type lease  revenues, representing sales of equipment at the inception of a lease in  which a dealer’s profit or loss is recognized |       | $                       | 16,142,000 |                    | $          | 1,108,000                |       | $ | 15,034,000 |   |
| Sales of  equipment from inventory                                                                                                             |       | 1,089,000               |       | 1,806,000               |       | (717,000                 | )          |
| Sales of  equipment coming off lease                                                                                                           |       | 504,000                 |       | 360,000                 |       | 144,000                  |       |
| Retail sales of  gaming equipment and merchandise                                                                                              |       | 262,000                 |       | 225,000                 |       | 37,000                   |       |
|                                                                                                                                           |       | $                       | 17,997,000 |                    | $          | 3,499,000                |       | $ | 14,498,000 |   |

 

The increase in sales-type lease revenues of $15.0million is primarily the result of a lessee purchasing leased equipment, whichhad previously been under operating leases. The Company is financing thepurchase of the equipment by the customer via sales-type leases.

Costs of equipment sales and sales-type leases totaled$15.6 million and $3.0 million in the six months ended June 30, 2004 and2003, respectively. The increase in costs corresponds to the increase inrevenues 

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from equipment sales andsales-type leases. Changes in margin, which were 13% in the six months ended June 30,2004 and 17% in the year-earlier period, result from a number of factors,including variations in supply and demand in the markets served by the Company.

Rental revenues from operating leases increased by$5.9 million, or 51%, to $17.4 million in the six months ended June 30,2004 from $11.5 million in the year-earlier period as a result of the Company’ssignificantly larger portfolio of operating leases, in relation to otherleases, in the current year. This portfolio increased to an average of $86.0million in the six months ended June 30, 2004 from $51.2 million inthe year-earlier period as a result of the Company’s aggressive sales efforts. Relateddepreciation increased to $11.5 million from $8.2 million in the six monthsended June 30, 2004 and 2003, respectively.

Finance income decreased by 19% to $1.8 million in thesix months ended June 30, 2004 from $2.2 million in the year-earlierperiod. This decrease reflects the fact that the Company’s portfolio of notesand leases receivable has declined between the two periods as a decliningpercentage of the Company’s new originations have resulted in notes and leasesreceivable.

Fee income decreased by 82% to $294,000 in the sixmonths ended June 30, 2004 from $1.6 million in the year-earlier quarter. Feeincome has historically fluctuated due to the timing of completion of largefinancing transactions, as well as the timing of the subsequent sale of notesand leases receivable.

Interest expense totaled $7.0 million in the sixmonths ended June 30, 2004 compared to $4.6 million in the year-earlierperiod. This increase of 51% results from higher average debt levels, resultingprimarily from new originations, and a higher weighted average cost of funds inthe six months ended June 30, 2004 compared to the year-earlier period. Theweighted average cost of funds, which includes the amortization of capitalizedloan costs, increased to 13.3% in the six months ended June 30, 2004 from12.4% in the six months ended June 30, 2003 due to market factors.

Selling, general and administrative expenses increasedby 36% to $2.4 million in the six months ended June 30, 2004 from $1.8million in the year-earlier period. The increase of $633,000 is primarily theresult of $320,000 in costs relating to taking the Company private and $267,000in increased payroll and related expenses.

The estimated effectiveincome tax rate was 40% in the six months ended June 30, 2004 as comparedto 36% in the year-earlier period. In both periods, the estimated effectiverate was higher than the federal statutory tax rate of 34% due primarily tostate income taxes and permanent tax differences.

**LIQUIDITY AND CAPITAL RESOURCES**

As of June 30, 2004, the Company had $6.7 millionin availability on lines of credit, $784,000 in cash and cash equivalents andrestricted cash of $4.2 million. The funds necessary to support the Company’sactivities have been provided by cash flows generated primarily from operatingactivities and various forms of recourse and non-recourse borrowings frombanks, financial institutions and financial intermediaries. Payments under theCompany’s borrowings and the maturities of its borrowings are typicallystructured to match the payments under the leases and notes collateralizing theborrowings. The Company manages its portfolio to optimize concentration amongcustomers and geographic markets. To achieve this goal, it will from time totime sell or externally finance transactions originated, including those heldin its investment portfolio. The Company continues to explore other possiblesources of capital, however, there is no assurance that additional capital, ifrequired, can be obtained or will be available on terms acceptable to theCompany.

Equipment vendors payable at June 30, 2004 was$5.1 million. Amounts due equipment vendors are generally settled with theproceeds of borrowings utilizing the underlying leases and related equipment ascollateral.

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At June 30, 2004, total borrowings were $120.9million, compared to $83.2 million at December 31, 2003. At June 30,2004, the Company’s revolving credit and working capital facilities aggregatedapproximately $15.7 million outstanding at interest rates ranging from 5.25% to10.50%. Advances under these agreements aggregated approximately $9.0 millionat June 30, 2004. The Company’s current financial resources, includingestimated cash flows from operations and the revolving credit facilities, areexpected to be sufficient to fund the Company’s anticipated working capitalneeds. The Company is, from time to time, dependent upon the need to liquidateor externally finance transactions originated and held in its investmentportfolio. The Company continues to explore other possible sources of capital;however, there is no assurance that additional capital, if required, can beobtained or will be available on terms acceptable to the Company.

Neither inflation nor interest rate fluctuations areexpected to have a significant impact on the Company’s operations or cash flowsin the foreseeable future.

In February 2003, the Company announced that ithad entered into a letter of intent with respect to a proposal submitted by themanagement group consisting of Johan P. Finley, the Company’s Chairman andChief Executive Officer, Lona M.B. Finley, the Company’s Executive VicePresident, Secretary and Chief Administrative Officer, and Peter D. Cleary, theCompany’s President, Treasurer and Chief Financial Officer (collectively, the “ManagementGroup”) to acquire all of the approximately 69% of the outstanding shares ofthe Company’s common stock not already owned by the Management Group. Under theterms of the letter of intent, the Company will pay certain fees and costs associatedwith the transaction, consisting primarily of legal costs and investmentbanking fees. Management estimates that remaining transaction costs will be inthe range of $100,000 to $200,000, with said costs being paid from generalcorporate funds.

In August 2004, oneof the Company’s largest customers announced that it had reached an agreementin principle with a significant portion of the holders of its largest series ofbonds to restructure the customer’s public indebtedness and to recapitalize thecustomer. The announcement indicated the customer intends to implement thetransactions through a Chapter 11 proceeding pursuant to a pre-negotiatedplan of reorganization. Based upon discussions with the customer, the Company’smanagement does not believe the Company’s transactions with the customer willbe adversely impacted.

**CASHFLOW**

During the six months ended June 30, 2004, cashused in operating activities totaled $7.1 million compared to cash used inoperating activities of $1.7 million in the prior year period. The increase incash used in operating activities of $5.4 million primarily reflects lowercollections of accounts receivable of $7.3 million and increased paydowns ofequipment vendors payable of $2.4 million, partially offset by higheroriginations of notes and leases receivable of $7.9 million.

The Company’s investing activities used net cash of$31.8 million during the six months ended June 30, 2004, compared to $14.9million in the prior year period. The increase of $16.9 million in net cashused in investing activities resulted primarily from an increase of $24.7million in the purchases of equipment to be placed under operating leases,which were $38.6 million in the first six months 2004 compared to $13.9 millionin the first six months 2003. This increase in purchases of equipment to beplaced under operating leases reflects the Company’s emphasis on originatingoperating leases rather than notes and leases receivable. A decrease inrestricted cash of $6.7 million partially reduced the net cash used ininvesting activities.

The Company’s financing activities provided $37.6million in net cash during the six months ended June 30, 2004, compared to$17.7 million during the prior year period. The increase of $19.9 million innet cash provided by financing activities was due primarily to an increase of$68.9 million in proceeds from borrowings, offset, substantially, by anincrease of $49.0 million in repayments of borrowings.

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

Market risk refers topotential losses arising from adverse changes in market rates and prices, suchas interest rates, foreign currency fluctuations and exchange rates, equityprices and commodity prices, including the correlation among these factors andtheir volatility.

**InterestRate Risk**

Substantially all of theCompany’s borrowings are under fixed interest rates, and maturities are matchedwith the cash flows of leased assets and notes receivables. A changing interestrate environment will not significantly impact the Company’s margins since theeffects of higher or lower borrowing costs would be reflected in the rates fornewly originated leases or collateralized loans. Therefore, consistent with theCompany’s strategy and intention to hold most of its originations to maturity,the Company does not have a significant exposure to interest rate changes forthe foreseeable future.

**CurrencyRisk**

The Company does not havea significant exposure to foreign currency risk because most of its sales areto customers in the United States and all of its sales to customers in foreigncountries are transacted in United States dollars.

**Forward-Looking Statements**

Certain statementscontained herein constitute “forward-looking statements” within the meaning ofthe Private Securities Litigation Reform Act of 1995. Such forward-lookingstatements may be identified by the use of terminology such as “believe,” “may,”“will,” “expect,” “anticipate,” “intend,” “designed,” “estimate,” “should” or “continue”or the negatives thereof or other variations thereon or comparable terminology.Such forward-looking statements involve known or unknown risks, uncertaintiesand other factors which may cause the actual results, performance orachievements of the Company, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Such factors include, but are not limited to,the following: strict regulation and changes in regulations imposed by gamingauthorities; the limitation, conditioning, suspension or revocation of gaminglicenses and entitlements held by the Company; new legislation, regulations,and court decisions that could impact Native American Gaming; competition theCompany faces or may face in the future; the effects of the proposed goingprivate transaction; uncertainty of market acceptance of the Company’s productsand services; uncertainties regarding the disposition of Rocky’s; a decline inthe public acceptance of gaming; unfavorable public referendums or legislation,particularly as they relate to gaming; the inability of the Company to continueto obtain adequate financing on acceptable terms; the inability of the Companyto recover its investment in gaming equipment leased under operating leases;the risk of default by the Company’s customers with respect to its financingtransactions; the Company’s dependence on key employees; potential fluctuationsin the Company’s quarterly results; general economic and business conditionsand other factors detailed from time to time in the Company’s reports filedwith the Securities and Exchange Commission.

**ITEM 4.   CONTROLS AND PROCEDURES**

**Evaluation of Disclosure Controls**

The Company evaluated the effectiveness of itsdisclosure controls and procedures as of the end of the second quarter 2004. Thisevaluation was done with the participation of the Company’s Chief ExecutiveOfficer and the Company’s President, Treasurer and Chief Financial Officer.

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Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed by us in the reports that the Companyfiles or submits under the Securities Exchange Act of 1934 (the “Exchange Act”)is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms. Disclosure controls and proceduresinclude, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed by us in the reports that we file underthe Exchange Act is accumulated and communicated to the Company’s management,as appropriate to allow timely decisions regarding required disclosure.

**Limitations on the Effectiveness of Controls**

The Company’s managementdoes not expect that the Company’s disclosure controls and procedures or theCompany’s internal controls over financial reporting will prevent all error andall fraud. A control system, no matter how well conceived and operated, canprovide only reasonable, but not absolute, assurance that the objectives of acontrol system are met. Further, any control system reflects limitations onresources, and the benefits of a control system must be considered relative toits 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, within the Company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty and that breakdowns can occur because of simple error or mistake.Additionally, controls can be circumvented by the individual acts of some persons,by collusion of two or more people, or by management override of a control. Thedesign of a control system is also based upon certain assumptions about thelikelihood of future events, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, controls may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate. Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error or fraud may occur and may not be detected.

**Conclusions**

Based on this evaluation, the Company concluded that,subject to the limitations noted above, its disclosure controls and proceduresare effective to ensure that information the Company is required to disclose inreports that it files or submits under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in SEC rules andforms.

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**PART II—OTHER INFORMATION**

**ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K**

a)               Thefollowing exhibits are included with this quarterly report on Form 10-Q asrequired by Item 601 of Regulation S-K.
| Exhibit Number | ** ** | ** **                                                                                                                     | ** ** | **Description** |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 31.1                |       | Certification by Johan  P. Finley pursuant to Section 302 of the Sarbanes-Oxley Act of 2003, 18  U.S.C. Section 1350 |
| 31.2                |       | Certification by Peter  D. Cleary pursuant to Section 302 of the Sarbanes-Oxley Act of 2003, 18  U.S.C. Section 1350 |
| 32.1                |       | Certifications pursuant  to Section 906 of the Sarbanes-Oxley Act of 2003, 18 U.S.C.  Section 1350              |

 

b)              Reports on Form 8-K.A Form 8-K was filed on April 2, 2004 announcing the Company’searnings for the fourth quarter and year ended December 31, 2003. A Form 8-Kwas filed on April 23, 2004 to report the announcement that the Companyhad entered into a definitive Agreement and Plan of Merger relating to theproposal of the Management Group toacquire all of the outstanding stock of the Company not already owned by them. Therewere no reports on Form 8-K during the period from June 30,2004 to the filing date of this Quarterly Report on Form 10-Q.

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**SIGNATURE**

Inaccordance with the requirements of the Securities Exchange Act of 1934, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                              | **PDS Gaming  Corporation**                                                     |
|------------------------------|---------------------------------------------------------------------------------|
| Dated: August 13,  2004 | By:                                                                             | /s/ Peter D. Cleary |   |
|                         | *President, Treasurer and Chief Financial Officer  (a duly authorized officer)* |

 

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