**UNITED STATES****SECURITIESAND EXCHANGE COMMISSIONWASHINGTON, 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 ENDEDMARCH 31, 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(Exactname of Registrant as specified in its charter)

 
| **Minnesota**                                                    | ** ** | **41-1605970**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  Jurisdiction of  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |

 

**6171McLeod Drive, Las Vegas, Nevada 89120**

(Address of PrincipalExecutive Offices)

 

**(702) 736-0700**

(Issuer’s TelephoneNumber, 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 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.     Yes  x     No  o

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

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the last practicable date:

 
| **Class**                     | ** ** | **Outstanding  as of May 6, 2004** |
|-------------------------------|------------|-----------------------------------------|
| Common Stock,  $.01 par value |       | 3,812,222                               |

 

 

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**PDS GAMING CORPORATION AND SUBSIDIARIES**

**INDEX**
| ** **                                              | ** ** | ** **                                                                                                   | ** ** | **Page**   |
|---------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|------------|
| **PART I   FINANCIAL  INFORMATION** |
|                                                    |       |                                                                                                         |       |       |
| Item 1.                                                 |       | Financial Statements:                                                                                        |       |       |
|                                                    |       |                                                                                                         |       |       |
|                                                    |       | Consolidated Balance  Sheets—March 31, 2004 (Unaudited) and December 31, 2003       |       | 3          |
|                                                    |       |                                                                                                         |       |       |
|                                                    |       | Consolidated  Statements of Income (Unaudited)—Three Months Ended March 31, 2004  and 2003    |       | 4          |
|                                                    |       |                                                                                                         |       |       |
|                                                    |       | Consolidated Statements of Cash  Flows (Unaudited)—Three Months Ended March 31, 2004 and 2003 |       | 5          |
|                                                    |       |                                                                                                         |       |       |
|                                                    |       | Notes to Consolidated Financial  Statements (Unaudited)                                                      |       | 6 - 7      |
|                                                    |       |                                                                                                         |       |       |
| Item 2.                                                 |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations        |       | 8 - 12     |
|                                                    |       |                                                                                                         |       |       |
| Item 3.                                                 |       | Quantitative and Qualitative  Disclosures About Market Risk                                                  |       | 13         |
|                                                    |       |                                                                                                         |       |       |
| Item 4.                                                 |       | Controls and Procedures                                                                                      |       | 13 - 14    |
|                                                    |       |                                                                                                         |       |       |
| **PART II   OTHER  INFORMATION**    |
| ** **                                              | ** ** | ** **                                                                                                   | ** ** | ** ** |
| Item 6.                                                 |       | Exhibits and Reports on  Form 8-K                                                                       |       | 15         |

 

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**PDS GAMING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                         | ** ** | **March 31,   2004** | ** **  | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                         | ** ** | **(Unaudited)**                | ** **  | ** **                  | ** ** |
| **ASSETS:**                                                                                                        |       |                           |        |                        |       |
| Cash and cash equivalents                                                                                          |       | $                              | 2,446,000   |                        | $          | 2,042,000 |   |
| Restricted cash                                                                                                    |       | 2,276,000                      |        | 10,886,000                  |       |
| Notes, accounts  and leases receivable, net of allowances                                                          |       | 27,823,000                     |        | 21,798,000                  |       |
| Equipment under  operating leases, net                                                                             |       | 87,103,000                     |        | 77,922,000                  |       |
| Equipment held  for sale or lease                                                                                  |       | 2,376,000                      |        | 1,984,000                   |       |
| Other assets, net                                                                                                  |       | 8,095,000                      |        | 9,201,000                   |       |
|                                                                                                               |       | $                              | 130,119,000 |                        | $          | 123,833,000 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY:**                                                                    |       |                           |        |                        |       |
| Equipment vendors payable                                                                                          |       | $                              | 2,675,000   |                        | $          | 21,767,000 |   |
| Accounts payable                                                                                                   |       | 236,000                        |        | 311,000                     |       |
| Customer deposits                                                                                                  |       | 5,038,000                      |        | 4,678,000                   |       |
| Notes payable                                                                                                      |       | 103,158,000                    |        | 77,643,000                  |       |
| Subordinated debt                                                                                                  |       | 6,000,000                      |        | 5,562,000                   |       |
| Accrued expenses  and other                                                                                        |       | 4,029,000                      |        | 5,056,000                   |       |
|                                                                                                               |       | 121,136,000                    |        | 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                                                                                                            |       | (2,883,000                     | )           | (3,041,000                  | )          |
|                                                                                                               |       | 8,983,000                      |        | 8,816,000                   |       |
|                                                                                                               |       | $                              | 130,119,000 |                        | $          | 123,833,000 |   |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME THREE MONTHS ENDED MARCH 31, (Unaudited)**
| ** **                                      | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-------------------------------------------------|------------|------------|------------|-----------|------------|
| **REVENUES:**                                   |       |       |       |      |       |
| Equipment sales and sales-type leases           |       | $          | 7,619,000  |      | $          | 1,905,000 |   |
| Operating lease rentals                         |       | 8,769,000  |       | 5,405,000 |       |
| Finance income                                  |       | 797,000    |       | 986,000   |       |
| Fee income                                      |       | 138,000    |       | 976,000   |       |
| Casino                                          |       | 25,000     |       | 163,000   |       |
|                                            |       | 17,348,000 |       | 9,435,000 |       |
| **COSTS AND EXPENSES:**                         |       |       |       |      |       |
| Equipment sales and sales-type leases           |       | 6,641,000  |       | 1,600,000 |       |
| Depreciation on leased equipment                |       | 5,908,000  |       | 3,775,000 |       |
| Interest                                        |       | 3,193,000  |       | 2,233,000 |       |
| Casino                                          |       | 240,000    |       | 311,000   |       |
| Selling, general and administrative             |       | 1,005,000  |       | 918,000   |       |
| Depreciation and amortization on other property |       | 96,000     |       | 192,000   |       |
|                                            |       | 17,083,000 |       | 9,029,000 |       |
| Income before  income taxes                     |       | 265,000    |       | 406,000   |       |
| Income taxes                                    |       | 107,000    |       | 146,000   |       |
| Net income                                      |       | $          | 158,000    |      | $          | 260,000 |   |
| Earnings per share—basic and diluted       |       | $          | 0.04       |      | $          | 0.07 |   |
| Weighted average  shares outstanding:           |       |       |       |      |       |
| Basic                                           |       | 3,806,000  |       | 3,802,000 |       |
| Diluted                                         |       | 3,928,000  |       | 3,802,000 |       |

 

See notes to consolidated financial statements.

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**PDS GAMING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE MONTHS ENDED MARCH 31, (Unaudited)**
| ** **                                              | ** ** | **2004**    | ** **  | **2003**    | ** ** |
|---------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **OPERATING ACTIVITIES:**                               |       |        |        |        |       |
| Net cash provided by (used in) operating activities     |       | $           | (14,100,000 | )           | $          | 12,282,000 |   |
| **INVESTING  ACTIVITIES:**                              |       |        |        |        |       |
| Purchase of equipment for leasing                       |       | (20,762,000 | )           | (12,675,000 | )          |
| Decrease (increase) in restricted cash                  |       | 8,610,000   |        | (1,021,000  | )          |
| Proceeds from sale of equipment under operating  leases |       | 742,000     |        |        |       |
| Purchase of fixed assets                                |       | (48,000     | )           | (50,000     | )          |
| Net cash used in investing activities                   |       | (11,458,000 | )           | (13,746,000 | )          |
| **FINANCING  ACTIVITIES:**                              |       |        |        |        |       |
| Proceeds from borrowings                                |       | 62,946,000  |        | 13,366,000  |       |
| Repayment of borrowings                                 |       | (31,431,000 | )           | (10,361,000 | )          |
| Repayment of subordinated debt                          |       | (5,562,000  | )           |        |       |
| Proceeds from issuance of common stock                  |       | 9,000       |        | 3,000       |       |
| Net cash provided by financing activities               |       | 25,962,000  |        | 3,008,000   |       |
| **CHANGE  IN CASH AND CASH EQUIVALENTS:**               |       |        |        |        |       |
| Net increase in cash and cash equivalents               |       | 404,000     |        | 1,544,000   |       |
| Cash and cash equivalents at beginning of period        |       | 2,042,000   |        | 115,000     |       |
| Cash and cash  equivalents at end of period             |       | $           | 2,446,000   |        | $          | 1,659,000 |   |

 

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 consolidated financialstatements have been prepared in accordance with generally accepted accountingprinciples for interim financial information and the instructions to Form 10-Qand Rule 10-01 of Regulation S-X. Accordingly, they do not include all ofthe information and disclosures required by generally accepted accountingprinciples for annual financial statements. In the opinion of management, alladjustments (including normal recurring adjustments) considered necessary for afair presentation have been included. The results of operations for any interimperiod are not necessarily indicative of results for the full year. For furtherinformation, please refer to the consolidated financial statements of PDSGaming Corporation (the “Company”), and the related notes, included within theCompany’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.

The balance sheet information at December 31,2003 was derived from the audited financial statements included in the Company’s2003 Form 10-K.

Certain amounts aspreviously reported have been reclassified to conform to the current yearpresentation.

**2.**   STOCK OPTION 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”),therefore, no compensation expense was recognized for the Company’s stockoption plans. Had compensation expense for the Company’s stock option plansbeen determined based on the fair value at the grant date for awards underthese plans, consistent with the methodology prescribed under SFAS No. 148,the Company’s net income (loss) and earnings (loss) per share would haveapproximated the pro forma amounts indicated below:
| ** **                                                             | ** ** | **Three Months Ended  March 31** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                             | ** ** | **2004**                                        | ** ** | **2003** | ** ** |
| Reported net  income                                                   |       | $                                               | 158,000    |   | $ | 260,000 |   |
| Reported earnings  per share—basic and diluted                    |       | 0.04                                            |       | 0.07 |   |
| Adjustment to  compensation expense for stock-based awards, net of tax |       | 48,000                                          |       | 114,000 |   |
| Pro forma net  income                                                  |       | 110,000                                         |       | 146,000 |   |
| Pro forma earnings per  share—basic and diluted                   |       | 0.03                                            |       | 0.04 |   |
|                                                                        |            |                                                 |            |  |  |  |  |

 

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.**   NOTES PAYABLE

Notespayable consist of the following:
| ** **                                                                                                                                                                                                    | ** ** | **March 31,  2004** | ** **  | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|-------------|-----------------------------|------------|
| Lines of credit  with a maximum aggregate balance of $17,237,000 bearing interest at rates  from 5.00% to 10.50%, secured by related investment in leases, equipment held  for sale or lease and other assets |       | $                        | 10,869,000  |                        | $          | 9,151,000 |   |
| Equipment notes bearing  interest at rates from 0% to 18.00%, secured by related investment in leases:                                                                                                        |       |                     |        |                        |       |
| Recourse                                                                                                                                                                                                      |       | 15,606,000               |        | 12,216,000                  |       |
| Non-recourse                                                                                                                                                                                                  |       | 77,420,000               |        | 56,978,000                  |       |
|                                                                                                                                                                                                          |       | 103,895,000              |        | 78,345,000                  |       |
| Unamortized loan  discounts                                                                                                                                                                                   |       | (737,000                 | )           | (702,000                    | )          |
|                                                                                                                                                                                                          |       | $                        | 103,158,000 |                        | $          | 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”) 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, whichwas signed by the Company and by the acquisition vehicle formed by the membersof the Management Group.

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 shares not owned by the Management Group, theprocuring of all necessary consents of the Company’s commercial lenders, thesecuring of required approvals from all gaming regulatory agencies, theobtaining by the Management Group of the necessary financing, and the receiptby the Company of a favorable fairness opinion from an investment bank.

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**ITEM 2.**   MANAGEMENT’SDISCUSSION AND 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 to operate TheGambler, now known as Rocky’s Casino and Sports Bar (“Rocky’s”), in Reno,Nevada. Due to continuing operating losses, the Company sought and was grantedapproval from the Nevada Gaming Control Board to temporarily cease operationsat Rocky’s effective January 31, 2004. Prior to that time, Rocky’s waslicensed to operate 180 slot machines. The Company is evaluating its futurealternatives for Rocky’s, which include sale, lease or joint venture of theproperty.

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 operating resultsare also subject to quarterly fluctuations resulting from a variety of otherfactors, including, but not limited to, (i) variations in the mix offinancing transactions between operating leases, direct finance leases andnotes receivable, (ii) changes in the gaming industry which affect thedemand for 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.

**SIGNIFICANTACCOUNTING 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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The following is a summary of what management believesare the critical accounting estimates and policies of the Company. Theapplication of these policies, in some cases, requires the Company’s managementto make subjective judgments regarding the effect of matters that areinherently uncertain. See Note 1, “Summary of Significant Accounting Policies,”to the Company’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.****  **TheCompany records revenue primarily in accordance with SFAS No. 13*, Accounting for 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.****  **Anallowance for losses is maintained at levels determined by the Company’smanagement to adequately provide for collection losses and anyother-than-temporary declines in other asset values. In determining losses, theCompany’s management considers economic conditions, the activity in usedequipment markets, the effect of actions by equipment manufacturers, thefinancial condition of customers, the expected courses of action by lesseeswith regard to leased equipment at termination of the initial lease term,changes in technology and other factors which management believes are relevant.Recoverability of an asset value is measured by a comparison of the carryingamount of the asset to future net cash flows expected to be generated by theasset. 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 net realizable value of the asset. Asset charge-offs arerecorded upon the disposition of the underlying assets. Management reviews theCompany’s assets on a quarterly basis to determine the adequacy of theallowances for losses.

**RESULTS OFOPERATIONS**

The Company reported net income of $158,000 or $0.04per diluted share in the first quarter 2004 compared to net income of $260,000or $0.07 per diluted share in the first quarter 2003. The Company completed$28.8 million in originations in the first quarter 2004 compared with $31.5million in the first quarter 2003. Originations in the first quarter 2004included $24.4 million, or 84.7%, sourced through two customers. Originationsin the first quarter 2003 included $28.1 million, or 89.2%, sourced through asingle, different customer.

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 the firstquarter 2004 totaled $17.3 million compared to $9.4 million in the year-earlierquarter, an increase of $7.9 million. This increase reflects higher levels ofrevenues from equipment sales and sales-type leases and operating leaserentals.

Revenuesfrom equipment sales and sales-type leases totaled $7.6 million in the firstquarter 2004 compared to $1.9 million in the year-earlier quarter, and aresummarized as follows:
| ** **                                                                   | ** ** | **March 31,  2004** | ** ** | **March 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|--------------------------|------------|
| Sales-type lease  revenues, representing sales of equipment coming off lease |       | $                        | 6,490,000  |                     |       |                     | $          | 6,490,000 |   |
| Sales of  equipment coming off lease                                         |       | 504,000                  |       | $                        | 109,000    |                     | 395,000    |   |
| Sales of  equipment from inventory                                           |       | 494,000                  |       | 1,688,000                |       | (1,194,000               | )          |
| Retail sales of  gaming equipment and merchandise                            |       | 131,000                  |       | 108,000                  |       | 23,000                   |       |
|                                                                         |       | $                        | 7,619,000  |                     | $          | 1,905,000                |       | $ | 5,714,000 |   |

 

Costs of equipment sales and sales-type leases totaled$6.6 million and $1.6 million in the quarters ended March 31, 2004 and2003, respectively. Changes in margin 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$3.4 million, or 63%, to $8.8 million in the first quarter 2004 from $5.4million 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 $82.5 million in thefirst quarter 2004 from $46.7 million in the year-earlier period,primarily as a result of the Company’s aggressive sales efforts. Relateddepreciation increased to $5.9 million from $3.8 million for the quarters endedMarch 31, 2004 and 2003, respectively.

Finance income primarily represents interest incomeearned from notes and direct finance leases receivable, and decreased to$797,000 in the first quarter 2004 from $986,000 in the year-earlier quarter. Thisdecrease reflects the fact that the Company’s portfolio of notes and directfinance leases receivable has declined in size during the past year.

Fee income decreased to $138,000 in the first quarter2004 from $976,000 in the year-earlier quarter. Fee income has historicallyfluctuated due to the timing of completion of large financing transactions, aswell as the timing of the subsequent sale of notes receivable and directfinance leases

Interest expense totaled $3.2 million in the firstquarter 2004 compared to $2.2 million in the first quarter 2003. This increase resultsfrom higher average debt levels, resulting primarily from new 

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originations, and a higherweighted average cost of funds in the first quarter 2004 compared to the firstquarter 2003. The weighted average cost of funds, which includes theamortization of capitalized loan costs, increased to 13.3% in the first quarter2004 from 12.7% in the first quarter 2003 due to market factors.

Selling, general and administrative expenses increasedto $1.0 million in the first quarter 2004 from $918,000 in the year-earlierquarter. The increase of $87,000 is primarily the result of increased payrolland related expenses of $214,000 and increased litigation costs of $95,000,partially offset by increased document fees received of $137,000 and decreasedconsulting costs of $82,000.

The estimated effectiveincome tax rate was 40% in the first quarter 2004 and 36% in the first quarter2003. In both periods, the estimated effective rate was higher than the federalstatutory tax rate of 34% due primarily to state income taxes and permanent taxdifferences.

**LIQUIDITY ANDCAPITAL RESOURCES**

As of March 31, 2004, the Company had $6.4million in availability on lines of credit, $2.4 million in cash and cashequivalents and restricted cash of $2.3 million. The funds necessary to supportthe Company’s activities have been provided by cash flows generated primarilyfrom operating activities and various forms of recourse and non-recourseborrowings from banks, financial institutions and financial intermediaries. Paymentsunder the Company’s borrowings and the maturities of its borrowings aretypically structured to match the payments under the leases and notescollateralizing the borrowings. The Company manages its portfolio to optimizeconcentration among customers and geographic markets. To achieve this goal, itwill from time to time sell or externally finance transactions originated,including those held in its investment portfolio. The Company continues toexplore other possible sources of capital, however, there is no assurance thatadditional capital, if required, can be obtained or will be available on termsacceptable to the Company.

Equipment vendors payable at March 31, 2004 was$2.7 million. Amounts due equipment vendors are generally settled with theproceeds of borrowings utilizing the underlying leases and related equipment ascollateral.

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 costsassociated with the transaction, consisting primarily of legal costs andinvestment banking fees. During the year ended December 31, 2003, $729,000of such costs were paid from general corporate funds. Transaction costs paid inthe first quarter 2004 were not significant. Management estimates thatremaining such costs will be in the range of $200,000 to $300,000, with saidcosts being paid from general corporate funds.

On February 6, 2004, the Company announced thereceipt of a financing commitment from Cochran Road, LLC, a New York-basedlender (“Cochran”), in the maximum amount of $9.5 million. Of the fundsavailable, the Company has drawn $6.0 million as of March 31, 2004. Thefunds drawn have been used for the redemption of the Company’s outstanding 10%and 12% Senior Subordinated Notes at par and working capital. At the time ofredemption of the Senior Subordinated Notes, in March 2004, theoutstanding principal balance of the notes was $5.5 million, of which $3.3million was due in July 2004. The Company drew the remaining $3.5 millionof the financing commitment in April 2004.

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Also on February 6,2004, the Company announced that the Management Group had received a financingcommitment from Cochran in a maximum principal amount of $5.5 million. Theproceeds from this financing are intended to be used to acquire all of theapproximately 69% of the outstanding shares of the Company’s common stock notalready owned by the Management Group.

**CASH FLOW**

During the first quarter 2004, cash used in operatingactivities totaled $14.1 million compared to cash provided by operatingactivities of $12.3 million in the first quarter 2003. The decrease in cashprovided by operating activities of $26.4 million primarily reflects anincrease in the paydowns of accounts and equipment vendors payable of $18.7million and a decrease in the collections of accounts receivable of $7.3million.

The Company’s investing activities used net cash of$11.4 million during the first quarter 2004, compared to $13.7 million duringthe first quarter 2003.  The decrease of$2.3 million in net cash used in investing activities resulted primarily from adecrease of $9.6 million in restricted cash, offset, in part, by an increase of$8.1 million in the purchases of equipment to be placed under operating leases,which were $20.8 million in the first three months 2004 and $12.7 million inthe first three months 2003. The increase in the purchases of equipment to beplaced under operating leases reflects the Company’s emphasis on originatingoperating leases rather than notes and direct finance leases.

The Company’s financing activities provided $26.0million in net cash during the first quarter 2004, compared to $3.0 millionduring the first quarter 2003. The increase of $23.0 million in net cash providedby financing activities was due primarily to an increase of $49.6 million inproceeds from borrowings, offset, in part, by an increase of $26.6 million inrepayments of borrowings.

At March 31, 2004, total borrowings were $109.2million, compared to $83.2 million at December 31, 2003. At March 31,2004, the Company’s revolving credit and working capital facilities aggregatedapproximately $17.2 million at interest rates ranging from 5.00% to 10.50%. Advancesunder these agreements aggregated approximately $10.9 million at March 31,2004. The Company’s current financial resources, including estimated cash flowsfrom operations and the revolving credit facilities, are expected to besufficient to fund the Company’s anticipated working capital needs. The Companyis, from time to time, dependent upon the need to liquidate or externallyfinance transactions originated and held in its investment portfolio. TheCompany continues to explore other possible sources of capital; however, thereis no assurance that additional capital, if required, can be obtained or willbe available on terms acceptable to the Company.

Inflation is not expected to have a significant impacton the Company’s operations in the foreseeable future.

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**ITEM 3.**   QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

**Interest Rate 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.

**Currency Risk**

The Company does not havea significant exposure to foreign currency risk because all of its sales tocustomers in foreign countries are transacted in United States dollars.

**Forward-LookingStatements**

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 thereofor other variations thereon or comparable terminology. Such forward-lookingstatements involve known or unknown risks, uncertainties and other factorswhich may cause the actual results, performance or achievements of the Company,or industry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements. Such factors include, but are not limited to, the following: strictregulation and changes in regulations imposed by gaming authorities; thelimitation, conditioning, suspension or revocation of gaming licenses andentitlements held by the Company; new legislation, regulations, and courtdecisions that could impact Native American Gaming; competition the Companyfaces or may face in the future; the effects of the proposed going privatetransaction; uncertainty of market acceptance of the Company’s products andservices; uncertainties regarding the disposition of Rocky’s; a decline in thepublic 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 ANDPROCEDURES

**Evaluation ofDisclosure Controls**

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

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 

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by us inthe reports that we file under the Exchange Act is accumulated and communicatedto the Company’s management, as appropriate to allow timely decisions regardingrequired disclosure.

**Limitations on theEffectiveness 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, itsdisclosure controls and procedures are effective to ensure that information theCompany is required to disclose in reports that it files or submits under theExchange Act is recorded, processed, summarized, and reported within the timeperiods specified in SEC rules and forms.

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**PART II—OTHERINFORMATION**

**ITEM 6.**   EXHIBITS ANDREPORTS 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**                                                                                                                                |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                           |
| 10.1                |       | Agreement and  Plan of Merger, dated as of April 14, 2004 by and among the Registrant,  PDS Holding Co., LLC and PDS Acquisition Sub, LLC |
| 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 January 22, 2004 to report the announcementthat the Company would be closing Rocky’s at midnight on Saturday, January 31,2004. A Form 8-K was filed on February 6, 2004 to report theannouncement that (i) the Company had received a financing commitment fromCochran in a maximum principal amount of $9.5 million, and (ii) the Management Group had received a financingcommitment from Cochran in a maximum principal amount of $5.5 million. AForm 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 Company had entered into a definitiveAgreement and Plan of Merger relating to the proposal of the Management Group to acquire all of theoutstanding stock of the Company not already owned by them. There wereno other reports on Form 8-K during the period from March 31,2004 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: May 17, 2004 | By:      | /s/ Peter D. Cleary                           |
| * *                 | * * | *President, Treasurer and Chief Financial Officer* |
| * *                 | * * | *(a duly authorized officer)*                      |

 

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