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PokerTek, Inc. (NASDAQ:PTEK)

Q2 2008 Earnings Call

July 29, 2008 5:00 pm ET

Executives

Mark Daniel Roberson - Chief Financial Officer

Christopher J.C. Halligan - Chief Executive Officer

Analysts

Todd Eilers - Roth Capital Partners LLC

Mark Smith - Feltl & Company

Unidentified Analyst

Operator

Welcome to the PokerTek second quarter 2008 earnings conference call. (Operator's instructions) I would now like to turn the presentation over to your host for today's call Mr. Mark Roberson, Chief Financial Officer.

Mark Roberson

Before we begin, please note that we may make forward-looking statements on today's call. These statements are made, pursue on to the Safe Harbor Provisions of the Securities and Reform Act and involve risks and uncertainties that may cause our result to differ materially from those expressed or implied. We undertake no obligations to publicly update or revise any such statements. Also, I strongly encourage you to read our public fillings for additional information.

I will start up today's call by reviewing our financial performance and after which Chris Halligan, our CEO, will provide commentary and then we will take your questions. Before we jumped in to the detail, I like to highlight a few specific points. Revenue in both the casino and amusement businesses continued to grow, operating expenses declined for the third quarter in a row, earnings and cash flow continue to show improvement, the company has successfully entered an important market with Trump Plaza in Atlantic City and subsequent to the end of the quarter, we closed the new credit facility with Silicon Valley Bank.

With that backdrop, we will discuss the financial results in more detail. Revenues were $3.8 million for the second quarter, growing 319% from the second quarter of 2007 and 20% on a sequential basis from the first quarter. On the year-to-date basis, our first half revenues were $7 million, up 367% from $1.5 million last year. As you know our revenues are derived from three primary activities; recurring casino licensing from lease tables, sales of casino products and sales of our Heads-Up Challenge amusement products but first let us talk about the casino business and then we will move to the amusement business, operating expenses earnings and the balance sheet.

Our PokerPro casino products delivered a strong performance in the second quarter as we continue to expand our footprint both domestically and internationally. For the first half, casino licensing revenues came in at $2.9 million, up 165% from $1.1 million in the first half of 2007 on a larger base of installed tables. For the quarter, casino licensing came in at $1.4 million, up 136% compared with the prior year and down 7% or $101,000 on a sequential basis from Q1. The decline in Q1 to Q2 was primarily the result of the following factors. During the first quarter, we had a one-time fee in connection with the Q1 installation of just over $80,000.

We did not have a summer amount in Q2 which cues the sequential comparison a bit. The cruise ship business continues to be an area of strength for us but experienced some seasonality when compared with the strong first quarter. During the second quarter, almost 40% of our cruise ship tables were on ship that repositioned to Alaska and Europe. Those are areas that draw different demographic and generally result in lower casino play in the Caribbean and other tropical itineraries that are more popular in the winter months. I would also note that almost all of our Q1 domestic installs were on cruise ships, by the way, but while we grow our table count for the quarter, we also reallocated some tables that we did not feel were in places where they could fully maximize the revenue potentials.

The actual impact on revenue from these movements was modest but more importantly, they are better positioned to increase recurrent revenues going forward. Those items were partially offset by new installations and including Atlantic City and the additional placement in Quebec. As there are new installations occurred very late in the quarter, however, they did not fully contribute to Q2. So, while licensing growth took a slight breather in Q2 following a big first quarter, we certainly believe we are better positioned for licensing growth to resume in the upcoming quarters. Our casino product sales, we sold $1.1 million of PokerPro products during the second quarter, an increase of 237% from prior year and 67% on a sequential basis.

For the first half, casino product sales were $1.7 million, an increase of 326%. These increases are almost entirely attributable to Aristocrat. However, Q2 product sales did include approximately 80,000 in consumable and other product sales which are a little higher than our normal run rate. In terms of units, we sold 19 PokerPro systems to Aristocrat during the quarter and 33 on a year-to-date basis. This compares to 3 units during the second quarter and 5 units during the first six months of 2007. Aristocrat has ramped significantly so far this year especially in Europe where they are opening new markets for PokerPro. In Bulgaria, for example, poker was only recently legalized and Aristocrat has placed over 20 tables with additional orders in the pipeline.

As you can see from the numbers, they are making real progress and we expect Aristocrat to continue to grow their PokerPro business. Overall we had a 27 net new PokerPro tables for the quarter bringing our count to 237. There are 237 tables, 170 were on lease by PokerTek in North America and 67 have been sold to Aristocrat for international customers. In the amusement business, revenues continue to grow driven by product sales in all markets but particularly by orders from our international distributors in Europe and Canada. Revenues from sales of Heads-Up challenge came in at $1.4 million for the quarter and $2.4 million for the first half. On a unit basis, we sold 303 units during Q2 bringing the total to 540 for the first half.

We have been pleasantly surprised by the performance of our international distributors and the demand for the product we received in Canada where approximately 2/3 of our sales have occurred during the year. Since we just launched this product in late 2007, there are no prior accounts to discuss but sales are ramping nicely for product that did not exists just a few quarters ago.

Moving on to operating expenses, total OpEx came in at $3.9 million for the quarter, an increase of 7% from the prior year and down sequentially 6.4% from Q1. As a percent of total revenue, operating expenses including non-cash depreciation and stock compensation improved to 102% for the quarter and 115% for the half. This compares favorably with 399% and 457% in the second quarter and first half of 2007. Operating cost has exhibited the turnaround over the past three quarters reaching a peak in the third quarter and then declining to the current level of $3.9 million.

The most recent reduction came primarily from trimming our head count at the beginning of the quarter. In the future, we will make the OpEx inch back up from current level as it grow particularly from depreciation as they grow table count. However, our goal is to leverage the infrastructure and continue to improve expenses when measured as a percent of revenues. I think it is important to note that the recent declines in our spending came in spite of significant growth and our employees have really keyed in on the importance of scrutinizing and challenging spending in all areas.

Additionally we recognized net interest expense for the first time during the second quarter of $39,000 as we began paying interest on the Founders and UBS logs. You will also note that we recognized $123,000 of income tax expense. This is the first time we have had income tax expense and is attributable to non recoverable taxes paid in Canada. When you add all that up, we reported the net loss of $1.9 million or $0.18 per share for the quarter compared with $2.8 million or $0.27 per share last year. For the first half, we reported the net loss of $4.1 million or $0.37 per share, an improvement from $5.4 million or $0.54 per share last year.

Turning to the balance sheet and cash flow, we closed the quarter with cash equivalents of $3.2 million and investment of $3.7 million. Cash used in operating activities came in at $3.0 million for the first half compared with $7.2 million in the first half of 2007. Cash used in operations has continued to turn favorably over the past few quarters as their operating results have improved.

On the liquidity front, we announced yesterday that we have entered into a new commercial banking relationship with Silicon Valley Bank to provide a working capital base credit facility. SVB is a $6.9 billion full service financial institution that specializes in providing banking services to growing technology companies and I believe they will be a valuable partner to PokerTek going forward.

Key terms of the new facility are as follows; re structure the $5 million credit facility with a one-year term, availability on the facility as based on specified percentages of our domestic and international accounts receivable and inventory totaling up to $4.1 million. Based on the recent level and composition of our accounts, we could have ordered a little over $2 million currently. So this facility provides us with head room for growth without having to renegotiate the new facility in the near term. Interest is at prime plus 1.5%. The relationship provides access to letter of credit facility and other banking services not previously available to the company.

Facility includes standard terms and additions including requirements for the achievement of either EBITDA or quick ratio covenant. There were no warrants issued or rather diluted features and it is basically straight commercial bank line of credit. Overall, Q2 was another step along the way to making PokerTek profitable. We see improved financial performance, continued progress in our markets, significant ramping of our revenues and improved working capital and expense managements. We are sure we are well positioned with leadership positions in both the casino and amusement businesses and we now have a financial partner in place to provide additional flexibilities as we continue to grow.

With that, I will the call back over to Chris.

Chris Halligan

When investors and perspective shareholders look at the company, there are few questions I want answered. Does the company address a big market? Do they have a competitive advantage? Do people want the things that they make? And is the company well run? At PokerTek, we feel we are answering all those questions better everyday. The markets we address are large in both the casino and the amusement space. Our first mover advantage continues to expand, demand for all of our products is up and our management team is delivering solid revenue growth, lower cost and balance sheet improvements. In short, Q2 was another positive step for PokerTek.

A few highlights, we are very pleased to be live at PokerPro at the Trump Plaza in Atlantic City. This is exactly the sort of customer we cultivated over the last few quarters. Trump is using PokerPro to offer poker to its patrons for the first time and their 100% PokerPro room delivers fast, air free play with a great environment for the players. Further, our business model means that Trump was able to open the room in a cost effective manner. It is a win for Trump, a win for their players and a win for PokerTek. We did forward the similar future opportunities in New Jersey following completion of our field trial. Second, we are excited by our expanded poker room at Loto-Quebec.

As you might know, we opened three poker rooms at Loto-Quebec in Q1 consisting of more than 40 tables. Q2 adds two more rooms with ten total tables at Ludoplex Quebec and Ludoplex Trois-Rivieres. When one of your best customers wants more of what you make, it is a good sign for your business. As Mark pointed out, our partnership with Aristocrat is flourishing. The combination of our great technology, very aggressive sales and marketing teams and new regulatory opportunities has created significant momentum. They continue to forge in new markets and are executing well in the worldwide opportunity for PokerPro.

Looking forward, we expect steady growth in our casino business and we are constantly working to improve the economics of our game for both ourselves and for our customers. For example, new hardware innovations could improve graphics performance, reduce product cost and increase overall product quality. Planned software developments may provide players of great new features that will add both to the fun of the game and the profitability for operators and we are always hard at work expanding our regulatory footprint both at home and abroad. We have a great game but we have not stopped.

A common topic I could ask about is the help of the overall poker market since we focus primarily on poker rooms. I would like to share our perspective on a continuing growth at poker. Our internal estimate counts more than 9,000 poker tables in casinos worldwide today. That is out from estimates of around 5,000 in 2005 and 7,200 two years ago. This growth was fed by several sources. The opening of new casinos, the opening of new poker rooms in existing casinos and the legalization of poker in new jurisdictions. From our point of view, all three of those trends seem sustainable.

Sometimes, we get excited internally by our present count of 237 PokerPro tables installed worldwide but we are proud of that growth, it is tampered by the realization that PokerPro represents less than 3% of the current world market. We have lots of room to grow. This year's world series of poker speaks further to poker's continuing popularity. Main event participants were up more than 7% and total entrants were up more than that over last year. The appeal of poker, the world's greater card game, is growing even in today's tough overall economic climate.

That sustained popularity contributed to the growth of our amusement business during Q2. Heads-Up challenge revenues grew almost 40% quarter on quarter, thanks to several factors including increased exposure, expanded distribution and most importantly, successful initial placements by our network of operators and distributors. Further supporting our Heads-Up challenge placement was an enhancement to our software which now allows multiplayer amusement tournaments for up to eight players. Just as with our PokerPro products, we are committed to expanding the Heads-Up challenge feature set and its earning power by offering new innovations for players.

Today, Heads-Up challenge is a great game and we address a large market but similar games have as many as 30,000 placements worldwide. We are up to a good start with our game with around 600 placements now worldwide but we know we have a tremendous opportunity in front of us and we are focused on that, not our past success. Beyond revenue, we demonstrated discipline in terms of cost management. SG&A cost declined sequentially in Q2, the third consecutive decline in SG&A for PokerTek. Our entire team understands the importance of carefully managing our resources.

I am also pleased with our ongoing balance sheet improvements, prudently reclaiming and reallocating PokerPro tables in the field improves our return on investment for all of our leased assets and our recently announced relationship with Silicon Valley Bank gives effect to additional working capital as our growth calls for it. Our partnership with SVB comes at the right time for PokerTek and we are delighted to be working with them. With regards to our pending lawsuit with [Live and Gaming 1714], there is no significant news to report. I reiterate, we intend to vigorously defend our position, we believe this lawsuit is without merit.

In review, PokerTek continues to make significant progress. Demand for our products are solid, revenue trends are positive, the markets we serve are large and we are managing our cost while making appropriate investments for the future. Lots of challenges remain but the opportunities abound and we feel very well positioned going forward. At this point, we would welcome your questions and I will turn the call back to the operator.

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from Todd Eilers - Roth Capital.

Todd Eilers - Roth Capital Partners LLC

If we could talk a little bit about the or you talk a little bit about the decline sequentially and license fees and you mentioned I think it was an $80,000 gain in Q1 and then some seasonality primarily related to your units in selling cruise ships. If we were to kind of back out the cruise ships, how did the rest of the installed do during the quarter and then secondly, the month of July here, the start of Q3, what are you seeing? Are we still seeing some seasonality or have you seen things pickup a little bit?

Chris Halligan

Yes, in terms of what we see in July to start off with, it is really too early to tell. We see those numbers from the cruise ships at the end of the month so we really do not get too much of the midmonth snapshot to be able to give you a much color there at this point. I expect the third ships that are in Alaska or still in Alaska so I presume July is probably going to look a whole lot like June but it will rebound as the seasonality changes later in the fall.

Mark Roberson

But Todd I would add that a lot of our land-based installations that occurred late in Q2 are really starting to kick in and we anticipate steady quarter on quarter revenue growth in the casino licensing line from Q2 to Q3. We took a little breather in Q2 but we expect to be back on track for Q3 and Q4 in that line.

Todd Eilers - Roth Capital Partners LLC

Okay, how much does the cruise ship represent, of your total installed base? I am not sure if you gave that or not?

Chris Halligan

Yes, we said we had 170 domestic tables, 59 of those are in cruise ships, end of the quarter. It is pretty significant part of our base.

Todd Eilers - Roth Capital Partners LLC

How does the backlog look for you guys right now? In Q1, I think you added 7 new units domestically and then it looks like 8 this quarter, is that kind of what we should expect going forward for the next couple of quarters. I know you do have, I am assuming you guys are going to place some units on the Shingle Springs Casino with legs that might be a nice addition for you guys in Q4 but aside from that is that, it is kind of that what we are seeing in the last couple of quarters. Is that where we should maybe expect going forward?

Chris Halligan

Yes, I think with that sort of a baseline that you can expect. We may spike up above that. We have several jurisdictions that we are just entering now for the first time. Some we are entering now, some they are on the cash bag and so I would anticipate growth that, at least, in line with what you have seen in the last couple of quarters, maybe a little ahead of that based on regulatory approvals but we got, I mean we anticipate from growth in Indiana, we actually opened in Indiana today, the Horseshoe Hammond, with two tables and some other opportunities there as we complete field trials in New Jersey. We have some other opportunities and there are some other New Jersey existing as well.

Todd Eilers - Roth Capital Partners LLC

Mark, question to your cost of sales, can you tell us how much of that was related to Aristocrat in international versus your entertainment on division?

Mark Roberson

Let me see if I have that exact number so that I can give you. In Q2, bear with me one second, cost of sales related to the Heads-Up Challenge product in Q2 was about $875,000.

Todd Eilers - Roth Capital Partners LLC

Okay and then tax, as you mentioned in the quarter, related to some unrecoverable taxes in Canada, is that a one time event or should we expect that to continue going forward? Should we be modeling that in?

Mark Roberson

Yes I mean that is certainly not a one-time event. I think there are some things that we can do structurally with our Canadian subsidiary and operationally to try to minimize that going forward in the future but we will certainly have some Canadian taxes in Q2 and I would make it into the forecast and then, we are going forward, we are hoping that we do some things that will cause that number to either go away or decline but for now, be certain with this and I would count on it being there.

Todd Eilers - Roth Capital Partners LLC

Okay and then just one final question with the new credit facility, do you guys feel that you are adequately capitalized to pursue your growth strategy at this point and should we not expect any more, I guess, capitalize raises or anything like that. Do you feel that you are in a good spot at this point?

Mark Roberson

Yes, we feel good about where we are right now. I think we have come a long way. We have improved, the financial performance is improving which has really helped the cash burn of the company that it has really turned around and if you look at our balance sheet now and our access to fund, and it has improved tremendously from where it was before we had this facility in place. I think right now we feel very good about our ability to execute with what we got.

Operator

Your next question comes from Mark Smith - Feltl & Co.

Mark Smith - Feltl & Company

Just a really quick question on your R&D expense, it looks like it dropped quite a bit here. Can you give us any guidance going forward on what we might be looking for on R&D?

Chris Halligan

Yes, I mean it dropped for a couple of reasons. We did trim back some head counts early in the quarter and it was kind of across the board but some of the guys were in the R&D side as well. We also, in previous quarters, have had continued spending on external spending on Heads-Up Challenge, R&D that is no longer with us. Going forward, I would not expect to see that decline any further. It may tweak back up a little bit as we continue to invest in R&D in both Heads-Up Challenge and the casinos live to improve the games and on hardware as well.

Mark Roberson

Mark, I just I would throw in there, I mean one of our objective is to constantly look at opportunities to reduce the cost of the game with all of our games and we are constantly we are going to software to make it more and more to the extent to which our games earn money. It is kind of a good barometer for the help of the company so we are always working on new innovations so we are going to invest in R&D.

Mark Smith - Feltl & Company

Can you give a breakdown of Heads-Up Challenge between domestic and international?

Chris Halligan

Yes. Well, for the quarter we saw 303 Heads-Up challenges. I will have to get back to you on the per-site breakout of domestic versus international but approximately 2/3 of that number was on international side.

Mark Smith - Feltl & Company

Okay and there is a lot of that, I guess, coming from Cosmic.

Chris Halligan

Quite a bit yes. Both Europe and Canada are performing very well for some Heads-Up Challenge side.

Mark Smith - Feltl & Company

Okay, because then it looks like Aristocrat is really doing a good job on the international front in your casino product, are they meeting the expectations? I mean could you just comment on how you feel about that relationship with this one?

Chris Halligan

Yes, we feel terrific about Aristocrat. They have been, I have said this before but a lot of times people have corporate partnerships and they say it is great and it is really now really very much of real thing. Our relationship with Aristocrat is terrific. Our people work together everyday. They performed extremely well. They are taking advantage of some great opportunities in Europe. There are some other good opportunity, they are kind of a behind that. There are some great opportunities elsewhere in the world and we could not be more pleased with our relationship with them. From the management perspective, we get good insights and feedbacks from them about growing the company so we are very pleased with Aristocrat and I think they are pleased with us too.

Mark Smith - Feltl & Company

Can you just give an update on any regulatory developments or things that are in the pipeline and that you, I guess, would be hopeful for in the next three to six months?

Chris Halligan

Mark, what are you asking about? We are obviously excited about the progress that we are making with some of the major dealers here in the United States and we are hopeful that we will have an announcement regarding Nevada at some point in the future but regulators perform a very valuable function and they make sure the games are safe and fair and we are going to the process and we hope to have an announcement sometime in the next three to six months, maybe sooner if things break right for us but we are constantly working on regulatory. Today, we started our field trial in Indiana, as I mentioned earlier. We are very excited about that and it is in Horseshoe Hammond There are some other customers that will come on line there we help as well and then there is some other significant jurisdictions both domestically in Canada and overseas that we have to crack and kind of near term future.

Mark Roberson

Just going back on your question, I just wanted to confirm that of the 303 units in the quarter, 101 of those were domestic.

Operator

Your next question comes from Unidentified Analyst.

Unidentified Analyst

Yes, out of those 67 of the machines with Aristocrat sold for you guys, how many of those are in the 50/50% of quick mode?

Chris Halligan

Right now that is about 15. Yes, it is just the minority. For those that are there now, we have a revenue sharing rate with Aristocrat whereby they recoup the revenue that they spend in purchasing the tables at the rate of 90% of the lease revenue until such time that they fully recoup the purchase price. After which time, we split revenues 50/50 and that is going to start to kick in greater numbers as time passes so that will be another driver toward your question about recurring revenue as those Aristocrat tables mature but today, it is the minority of the tables because most of their installations are leases.

Unidentified Analyst

Okay and then on the cost side, how much more can we expect operating expenses to come down? You have done the three quarters in the row; can we expect that going forward?

Chris Halligan

Yes, I mean at this point I think we probably hit a good point as far as our operating cost. I think we have leveraged the infrastructure to the point that, I think that we will continue to leverage the infrastructure as we grow revenues. So, you are going to see the percent of OpEx decline but I think the raw dollars, SG&A, R&D and depreciation, depreciation is certainly going to increase as we move forward and grow the table base. SG&A and R&D, I think, are probably going to stay flat to increase slightly in the future as we continue to grow the business and add a few resources back. So, overall we are going to manage it. I do not think we are going to take actions that are going to take a whole lot more out of in the near term.

Operator

We do not have any more questions in queue.

Chris Halligan

Well, we are glad everyone made the time for us today. We continue to work very hard for our customers and our shareholders. We appreciate your interest and I will just remind everyone, we are going to be at the Noble Conference in August in Las Vegas so if any investors would like to have a one on one with management, we will be able to do that. So, thank you.

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Source: PokerTek, Inc. Q2 2008 Earnings Call Transcript

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