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PokerTek, Inc. (NASDAQ:PTEK)

Q3 2013 Earnings Conference Call

November 7, 2013 11:00 AM ET

Executives

Mark Roberson - CEO, CFO and Treasurer

Analysts

Tom Pierce - Van Clemens

Operator

Good day ladies and gentlemen, and welcome to the Q3 2013 PokerTek Inc. Earnings Conference Call. My name is Karen and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this call is being recorded for replay purposes.

And now, I’d like to turn the call over to Mark Roberson, Chief Executive Officer, please go ahead.

Mark Roberson

Thank you, Karen. Good morning. Before we get started with the review of the quarter, I would like to remind you that today’s call is being webcast, and that certain statements we make may constitute forward-looking statements for the purposes of the Safe Harbor Provisions under Federal Securities Law. Our actual results may differ from the expectations expressed and the company assumes no responsibility to update forward-looking statements as a result of new information or future events.

Today’s discussion will include non-GAAP financial measures, specifically EBITDAS, a reconciliation of EBITDAS to GAAP net income is included with the earnings release filed this morning on Form 8-K. Also, please refer to our annual report and other filings with the SEC the information regarding the risks and uncertainties inherit in our operations.

Financial results for the first nine months were solid, our recurring revenue base is strong and stable, generating a high gross margin and resulting in improved bottom line operating results. At the beginning of the year, we communicated four focused objectives for 2013; one, increased penetration in our current markets; two, enter new markets; three, obtain regulatory approval for our ProCore platform, and four continue to leverage our cost structure to drive EBITDA and EPS improvement.

With regard to the first objective of increasing placements in our current geographic market, we made good progress in several markets but also encountered a set back in the Ohio market where we announced the removal of 20 tables in September, due to new interpretations of the state security gaming regulations.

We’ve spoken with several parties in the state government and are receiving feedback that language is being drafted that we serve to clarify the regulations to allow to us to operate electronic tables. However while we are hearing positive indications we also know that political processes are unpredictable and our focus in other markets [is a fresh tie] as Ohio reopens.

In the cruise market which has been the anchor for our business for many years, we signed a new contract with MCS, the third largest cruise line in the world. We shipped 80 gaming positions in Q3 with installations being performance in October and November. It is a matter fact our technical staff has been sailing on several of those ships the past two weeks training the onboard ship staff. Those new installations will be reflected in our fourth quarter numbers. We also installed tables at new locations in the United States, in Las Vegas and Oklahoma and on cruise ships during the quarter.

We are focusing a lot of energy on entering new markets where electronic games has a high potential for growth. As recently announced, we received approval and entered the Macau gaming market a few weeks ago. While the final approval process took much longer than we initially predicted and pushed out of Q3 and into Q4 the result will certain work the way. We now have six PokerPro tables with 60 gaming positions in the PokerStars LIVE, poker room and Melco Crown’s City of Dreams property.

Early indications are that levels of play and overall reception of the games are exceeding expectations. I believe we have a number of new listeners on the call today. So for those who may not be familiar with the situation in Macau, we can walk to a brief background and why Macau is a good market for e-tables.

Everyone I am sure is aware that Macau is the largest gaming market in the world and continues to expand. The characteristics however that is less well known and very important for e-tables is that Macau has unique regulations that impose strict restrictions on the number of manually dealt table games allowed in the province.

Those regulations currently allow approximately 5,500 tables and that number is already been fully allocated to existing properties. In other markets casinos make decision about which games to offer based on things like available square footage because that constraint that space. In Macau however the constraint is not available for space but the table cap which forces casino operators to make resource allocations decisions about how many baccarat games they allow for versus poker blackjack and other games. Because baccarat is by far the most popular and profitable game in Macau, poker and other games are being displaced. The problem that is expected to become even more acute with several new casinos currently under construction.

At present there are only a handful of manually dealt poker games left on the Cotai strip and downtown areas of Macau with those that do [candling] only to very high limit players. This leads a significant unmet demand from Asian poker players, especially for the most popular mainstream games like [1, 2]. Because electronic tables do not count towards the table cap that creates significant opportunities for electronic solutions in the Macau market with PokerPro now live, we'll focus on supporting those first tables and making them as successful as possible, while building player and operator awareness in the market.

Because of the table cap, we believe there is room for significant growth in Macau and are starting to receive more increase and interest with the tables now on the floor and generating buzz in the market.

In South America, as we discussed on our August conference call, we shift 15 tables to Columbia in late Q3. Those tables are just now clearing customs and starting to become available through installation at customer locations. I expect initial installations to start this month and early December and force to have the initial shipment fully installed in generating revenue within three to four months. While there are several large and attractive markets in South America, where we plan to expand, Columbia is the initial focal point of our South American strategy.

Columbia has approximate 400 casino properties, most of which are electronic only. In Central Bogota there are two full service casinos offering both slots and live table games. For the outline areas of Bogota as well as other highly populated areas of the country, the landscape is dominated by slot and bingo properties. In those properties, our electronic tables can bring a full service casino experience by adding poker and other table games. This is a model that is proven very successful in other markets and we believe has tremendous potential in Columbia.

Other markets in the region such as Peru and Argentina has similar favorable characteristics and high potential. Lima and Buenos Aires for example are each home the one or two full service properties with the remaining areas of those markets underserved with table games which should create large opportunities for e-tables over the next several years. Our Head of International Sales will be attending a SAGSE Trade Show in Buenos Aires this week, meeting with customers and will be spending a large portion of his time in Colombia for next several months, to support our distributors and new customers, building on the initial installations to accelerate growth in early 2014. The first stated objective was to achieve regulatory approval for our ProCore product.

The ProCore hardware platform along the Blackjack and EZ Baccarat received official approval from GLI in September. With ProCore now approved we're able to market the games to customers in all GLI markets which includes most U.S. markets as well as British Colombia, Macau and other regions. In addition to Colombia we're currently installing does not currently required GLI but will begin requiring GLI certifications starting next year. So GLI is an - in almost all the areas where we operate.

Fourth after several rounds of restructuring over the past several years that reduced the company’s annualized operating expenses burden from a peak of over $17 million in 2007 to just under $5 million today. Our cost structure was appropriately sized for our business and scalable so that our costs should remain relatively stable as we grow. During Q3 and the nine month period our operating expenses did increase modestly due to a non-recurring bad debt write-off related to Ohio and a liberate investments in R&D and product approvals. Those expense items should taper future periods, while the investment in R&D and approvals should benefit future revenue growth.

Moving to the financials of recently recap to reported results for the quarter and the nine months. Total revenue increased 8% to $4.1 million year-to-date and 3% to $1.1 million for the quarter. Recurring revenues from product leasing increased 20% for the first nine months and 3% for the quarter, while revenue from hardware sales decreased 43% and 17%.

There are several dynamics underlying those revenue comparisons. First, recurring revenue from Canada, Mexico, and Cruise ships increased as we had new installations come online at the end of last year and during the first half of this year has generated new recurring revenue in the current year period.

The growth in recurring revenue in Canada, Mexico in Cruise ships was also however by reductions in a couple of other areas. We continue to see soft economic conditions in Eastern Europe and France and as a result deemphasize those markets temporarily.

In the United States in the first half of both 2012 and 2013 we had customers come to us and request to convert their arrangements from lease to purchase so they could own new table hardware. The practical effect of lease conversions is that increase to product sale revenue in the first half of both years, while decreasing our licensing revenue recognized during the third quarters of ‘13 and ‘12.

When customers come back and ask the purchase leased equipment that they’ve operating for long period of time, we do view as a highly positive indicator regarding their long-term view of E Table adoption and player acceptance, as well as how perceive the quality of our products and our service. I would also emphasize that when we sell hardware or convert leases the sold hardware normally continues to generate recurring maintenance and licensing fees and perpetuity.

Our overall target is recurring revenue to track near 85% of total revenue with equipment sales balancing out at 15%. For the current quarterly period, our revenue was almost entirely recurring coming in at 98% to 99% of total revenue in both years due to the timing of equipment sales. On a year-to-date basis we are tracking closer to target with 90% recurring in 2013 and 80% recurring in 2012. Looking ahead I would continue to expect us to track nearly 85% level with much stronger product sales activity in Q4 than we had in Q3.

In addition when looking at the Q3 and year-to-date revenue and gaming position numbers, it’s important to keep in mind that although we already shipped quite a few games to Macau, Columbia and [MSP] cruse ships in earlier months those installations are not reflected in the Q3 or year-to-date numbers. Those installations will be reflected in Q4 to coincide with [GLI] and completion of the revenue recognition process.

Gross margins remained strong at 73% for the quarter and 75% year-to-date. Margins have been consistently running at 70% or better for the past two years. We expect longer term margins to be sustainable at current levels, while individual quarters will vary in the mid 60% to mid 70% range. Operating expenses remained well controlled increasing 4% for the quarter and 5% for the nine months.

We brought down employee compensation and professional fees that incurred higher bad debt expenses largely right into Ohio, relative to level of expense and expense more than usual on product approvals and R&D. With GLI approval obtained, I would expect those expenditures to taper down in future periods.

Interest income tax expenses were significantly lower as reduced debt and now have less than 300,000 of long-term debt on the balance sheet. We are also able to eliminate non-recoverable foreign taxes incurred in prior periods reducing our overall income tax expense to zero for the quarter.

Net loss improved by 23% from last year on a year-to-date basis and 18% on a quarterly basis. EPS was negative $0.03 per share for the quarter and $0.06 for the first nine months including 25% on a quarterly basis and 33% on a year-to-date basis. We’re EBITDA positive and delivered positive cash from operations for the year-to-date period. Overall, a solid financial performance with solid momentum coming into Q4 in 2014.

With that we’ll conclude the formal remarks and open the line to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) First question comes from the line of Tom Pierce of Van Clemens. Please go ahead.

Mark Roberson

Good morning, Tom.

Tom Pierce - Van Clemens

Good morning to you, how are you doing?

Mark Roberson

I am doing well, how are you?

Tom Pierce - Van Clemens

Good. I thought your press release was very well. A question for you is that PokerStars is a big name in gaming and you guys seem to have some kind of special relationship to them. Can you maybe explain how that relationship works?

Mark Roberson

Yes, yes. Obviously PokerStars is a big name in the industry and we are excited to be working with them in Macau. PokerStars life is the operator of the poker room in City of Dreams in Macau. So when we look at Macau, we really have two customers, both -- as the operator of the property and PokerStars as the operator of the poker room within the property. So we're really just getting started with that relationship through the Macau partnership and then obviously we hope to expand as we move forward.

Tom Pierce - Van Clemens

I know that PokerStars have been trying to get into the US via buying a hotel or a casino, are they making any headway?

Mark Roberson

You hear they’ve been working on that for a while, I can't really comment as to the progress that they’ve made or their plans with regards to that other than what you see in the press.

Tom Pierce - Van Clemens

Okay. So just another question, you’ve commented about Ohio and I was just wondering what your gut feel tells you about re-entering Ohio?

Mark Roberson

It's always cut to say, because we're dealing with politics and politician. The background of the situation is there are mixed or I should say conflicting rules in the regulations as they have been adopted overtime in Ohio with regard to definitions of gaming equipment. So there are different definitions in the [regs] that conflict with regulations that were adopted in the constitution when the casinos came on board and the attorney general of Ohio in my opinion at the [6th Forum] is really seeking to push the legislature to clarify and flipping regulations that his office has charged with enforcing, it’s very difficult to do your job when the rules aren’t clear, so we totally get that.

My gut feel is that I think that the towers in Ohio really don’t have an interest in furnishing the charities by not allowing them to fund raise through gaming activities that they have been engaged in for years. And I believe that the legislature is simply sensitive to that and our hope is that new regulations will be issued or clarified that allow the charities to continue to engage in fund raising through the use of both games in their properties as well as charity [trust]. However I'll say that we all know from Washington and elsewhere how political properties work so it’s very difficult to say what politicians will do, we can only speculate at this time.

Tom Pierce - Van Clemens

Is there any timing on when they could reach some decision?

Mark Roberson

My understanding is that the legislature is in session right now in October and November. I don’t know if we will hear something during that timeframes during the current session. I know it will be discussed or if they will get pushed into next year, but they certainly are in session during the fourth quarter of this year.

Tom Pierce - Van Clemens

Well, thank you very much.

Operator

(Operator Instructions). Next question we have from (inaudible). Please go ahead.

Unidentified Analyst

Mark, can we go back to Tom’s question if I have to PokerStars. I understand it’s worldwide, is your arrangement with them going to just cover the individual casino in Macau or does it encompass their other operations, in other words are you going to supply in the PokerStars elsewhere?

Mark Roberson

At this moment the arrangement is solely related to Macau in connection with their operations with that room. Obviously from our view point, we view that, it’s hopefully a start something where we can have a broader relationship down the road, but as of this moment, we are starting, are working with PokerStars solely with Macau. We’re talking of them about some branding opportunities in other markets, but that will be something potentially down the road not as (inaudible).

Unidentified Analyst

Okay. And one last thing, have you had any conversations with those folks about blackjack and easy baccarat?

Mark Roberson

Yes. We are -- obviously Macau is a large baccarat market, almost 90% or probably more than that as the revenue Macau comes from baccarat and the baccarat games are affected by the table gap just as poker is in terms of limiting the supply, but we’re able to meet demand. Now we believe that the easy baccarat product would be a good solution for that market. And we’re obviously going to be talking to folks in the market about that. There are a few more processes as we’ve seen with poker. We have been engaged with the GLI approved product, but it took us six to nine months to get through the local approval process with poker.

So while we are looking at easy baccarat the market has high expectations, it’s going to take us a little bit of time to get that product into the market just because of the backlog at the local level from a regulatory standpoint. So our strategy right now is to really focus on this initial poker installation, it’s performing very well, it’s getting good reviews and that’s creating some buzz in the market and hopefully some interest in our products. We will leverage that success hopefully to grow the poker footprint and then also to bring an easy baccarat in 2014.

Unidentified Analyst

Good. Thank you, Mark.

Operator

I think we have no question. I’d now like to turn the call over to Mark Roberson for closing remarks.

Mark Roberson

Thank you. We are closing the year out quite busy with the installations in Macau, South America cruise ship and other markets and we look forward to reporting our Q4 results to you in early 2014. Have a good afternoon and once again thank you.

Operator

Thank you for joining today’s conference. This concludes the presentation. You may now disconnect. Have a very good day.

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