10-Q 1 q2-02anchor.txt Q2 2002 ANCHOR GAMING UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 29, 2001 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to ____________ Commission file number 000-23124 ANCHOR GAMING (Exact name of registrant as specified in its charter) Nevada 88-0304253 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 815 Pilot Road, Suite G Las Vegas, Nevada 89119 (Address of principal executive offices) (Zip Code) (702) 896-7568 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No - - Shares outstanding of the registrant's common stock as of January 26, 2002: Class Outstanding as of January 26, 2002 ----- ----------------------------------- Common stock, $0.01 par value 100 Table of Contents Part I - Financial Information Page Item 1. Financial Statements: Condensed Consolidated Statements of Income - Three and Six Months Ended December 29, 2001 and December 31, 2000.. ................................4 Condensed Consolidated Balance Sheets - December 29, 2001 and June 30, 2001 ..........................6 Condensed Consolidated Statements of Cash Flows - Six Months Ended December 29, 2001 and December 31, 2000......7 Notes to Condensed Consolidated Financial Statements.............9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................19 Item 3. Quantitative and Qualitative Disclosures About Market Risk......29 Part II - Other Information Item 1. Legal Proceedings...............................................30 Item 2. Changes in Securities...........................................30 Item 3. Defaults Upon Senior Securities.................................30 Item 4. Submission of Matters to a Vote of Security Holders.............30 Item 5. Other Information...............................................30 Item 6. Exhibits and Reports on Form 8-K................................30 Signatures...............................................................31 Part I - Financial Information Item 1. Financial Statements General The following unaudited condensed consolidated financial statements were prepared by Anchor Gaming (referred throughout this document, together with its consolidated subsidiaries where appropriate, as Anchor, Company, we, our, and us) and include all normal adjustments considered necessary to present fairly the financial position for the interim periods. These adjustments are of a normal recurring nature. These financial statements and notes are presented as permitted by the instructions to Form 10-Q and therefore do not contain certain information included in our audited consolidated financial statements and notes for the year ended June 30, 2001. Operating results for current periods do not necessarily indicate the results that may be expected for the fiscal year ending June 29, 2002. You should read these financial statements along with the financial statements, accounting policies and notes included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2001. We believe that the disclosures in this document are adequate to make the information presented not misleading. Certain amounts in the unaudited condensed consolidated financial statements presented for the comparable prior year period have been reclassified to be consistent with the presentation used in the current fiscal period. Condensed Consolidated Statements of Income

The accompanying notes are an integral part of these condensed consolidated financial statements. Condensed Consolidated Statements of Income

The accompanying notes are an integral part of these condensed consolidated financial statements. Condensed Consolidated Balance Sheets

The accompanying notes are an integral part of these condensed consolidated financial statements. Condensed Consolidated Statements of Cash Flows

The accompanying notes are an integral part of these condensed consolidated financial statements. Supplemental Cash Flows Information

The accompanying notes are an integral part of these condensed consolidated financial statements. Notes to Condensed Consolidated Financial Statements 1. Summary of Significant Accounting Policies: Change in Quarter End On December 26, 2001, the Company and IGT filed Articles of Merger with the Nevada Secretary of State. Under this filing, the merger became effective December 30, 2001 (See Note 12). To conform to the quarterly periods used by IGT, Anchor changed its quarter-end date to the Saturday closest to December 31 in the current quarter. Similarly, subsequent quarters will end on the Saturday closest to the last day of the quarter-end month. Investment in Unconsolidated Affiliate Anchor accounts for its joint venture with IGT, the Spin for Cash Wide Area Progressive Joint Venture (Joint Venture) as an investment in unconsolidated affiliate under the equity method. Under the equity method, original investments are recorded at cost and adjusted by the Company's share of earnings, losses and distributions of the affiliate. The primary business of the Joint Venture is to distribute gaming machines on wide-area progressive systems. The Company's share of net earnings from the Joint Venture and related activities are included in earnings of unconsolidated affiliates. The Joint Venture has a September 30 fiscal year-end. Summarized results of operations for the Joint Venture are as follows:

Depreciation expense for the Joint Venture was $8.5 million and $7.2 million for the quarters ended December 29, 2001, and December 31, 2000. For the six-month periods ended December 29, 2001 and December 31, 2000, depreciation expense was $17.3 million and $13.9 million. Revenue Recognition In accordance with industry practice, the Company recognizes gaming revenues as the net win from gaming operations, which is the difference between amounts wagered by customers and payments to customers. Revenue derived from royalty, revenue participation, or other similar short-term recurring revenue arrangements is recognized as it accrues. Revenue is normally recognized based on the Company's share of coins wagered, on its share of net winnings, or on the lease rate. Revenues exclude the retail value of complimentary food and beverage furnished gratuitously to customers. Revenue is also reported net of cash rebates accrued to customers as part of the Company's loyalty programs. Notes to Condensed Consolidated Financial Statements Revenue from the sale of gaming and systems equipment and related parts is recognized upon delivery to the customer. Revenue from sales of lottery, pari-mutuel and video gaming central site systems (including customized software and equipment) is recognized using the percentage of completion method of accounting for long-term construction type contracts where costs to complete the contract can reasonably be estimated. Prior to revenue recognition on system sales, costs incurred are applied against progress billings and recorded as a net accrued liability or other current asset as appropriate. Systems contract services revenues are recognized as the services are performed and primarily relate to revenues from long-term contracts which require installation and operation of lottery and pari-mutuel wagering networks. Revenues under these contracts are generally based on a percentage of sales volume, which may fluctuate over the lives of the contracts. 2. Inventory Inventories, net of valuation reserves, are as follows: December 29, June 30, 2001 2001 ----------------------------------------------------------------------- (in thousands) Raw materials $ 5,145 $ 4,602 Work-in-process 366 562 Finished goods 11,352 9,646 ------- ------- $16,863 $14,810 ======= ======= 3. Other Current Liabilities Other current liabilities are as follows: December 29, June 30, 2001 2001 ----------------------------------------------------------------------- (in thousands) Labor, compensation and benefits $ 8,414 $11,454 Interest expense 5,575 6,455 Accrued restructuring expense 4,059 5,036 Accrued liquidated damages 1,331 5,532 Other accrued expenses 15,682 17,322 ------- ------- $35,061 $45,799 ======= ======= Liquidated damages are accrued when they are probable and can be reasonably estimated. Failure to perform under lottery contracts may result in substantial monetary damages. At June 30, 2001, our liability for liquidated damages primarily related to our on-line lottery contract with the state of Florida. Automated Wagering International (AWI), our on-line lottery company, paid $4.5 million in July 2001 to the Florida State Lottery. Notes to Condensed Consolidated Financial Statements 4. Impairment of Assets and Restructuring Charges Impairment Charge During fiscal 2001, the Company, in accordance with Statement of Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of SFAS 121, recorded impairment charges of $119.5 million. Goodwill, intangible assets and property, plant and equipment were impaired $68.4 million, $17.1 million and $34.0 million. Restructuring and Other Charges In the third quarter of fiscal 2001, the Company commenced a restructuring plan (primarily at AWI), which continued in the fourth quarter. Total restructuring and other charges were $9.9 million for fiscal 2001. The major components of the charges relate to the consolidation of operations within existing facilities, the termination of certain contracts for leases and consulting, and the elimination of positions. Management of the Company believes that all activities under the restructuring plan were substantially complete by the end of fiscal 2001. A summary of the impairment, restructuring and other charge activity as well as the amount of remaining accruals is as follows:

Notes to Condensed Consolidated Financial Statements 5. Earnings Per Share A reconciliation of income and shares for basic and diluted earnings per share (EPS) is as follows:

6. Divestitures Sale of Montana Slot Route Assets In the third quarter of fiscal 2001, management of the Company committed to a plan to sell the Montana slot route assets by March 31, 2002. On September 28, 2001, the Company sold the Montana slot route assets for $5.2 million and recorded a gain of $2.0 million. For the three months ended December 31, 2000 and the six months ended December 29, 2001 and December 31, 2000, the operations of the Montana slot route contributed the following amounts: Notes to Condensed Consolidated Financial Statements

Pala Management Contract On December 23, 2001, the Company entered into an agreement with the Pala Band of Mission Indians and Jerome H. Turk to surrender its portion of the management agreement for the Pala Casino in San Diego, California, subject to conditions. Upon completion of the transaction, which is expected in February 2002, Mr. Turk will become the sole owner of the management company that has the management contract for the Pala Casino. The Pala Band of Mission Indians will pay Anchor $77 million, consisting of $14 million payable in cash at the closing, and $63 million payable by delivery of a subordinated secured promissory note. Assets associated with the Pala management contracts are classified as available for sale in the accompanying balance sheet as of December 29, 2001. 7. Contingencies Anchor has been named in and has brought lawsuits in the normal course of business. We do not expect the outcome of these suits, including the lawsuits described below, to have a material adverse effect on our financial position or results of future operations. GTECH In February 1999, GTECH Holdings Corporation filed a complaint for declaratory judgment, injunction, and violation of the Public Records Law against the State of Florida, Department of Lottery and AWI in the Circuit Court, Second Judicial Circuit, in Leon County, Florida. The complaint requests the Circuit Court to declare the contract between AWI and the Florida Lottery void in the event the First District Court of Appeal of Florida upholds the Florida Lottery's decision to award the on-line lottery services contract to AWI. On July 22, 1999, the First District Court of Appeal affirmed the Florida Lottery's award of the contract to AWI. In March 1999, AWI and the Florida Lottery executed an amended contract. On January 28, 2000, the Florida Circuit Court determined that the amended contract materially differed from the Request for Proposal and declared the amended contract null and void. The Florida Lottery appealed on February 2, 2000, affecting an automatic stay of the Circuit Court's order. AWI appealed on February 10, 2000. On February 28, 2001, the Florida First District Court of Appeal affirmed the order of the Circuit Court. Both AWI and the Florida Lottery petitioned the Court of Appeal for a rehearing or certification of questions to the Florida Supreme Court. On July 17, 2001, the Court of Appeal granted these motions. Both AWI and the Lottery have petitioned the Florida Supreme Court to consider the questions certified by the Court of Appeal and also to stay enforcement of the Order of the Circuit Court. Notes to Condensed Consolidated Financial Statements AWI continues to provide its on-line gaming services and products to the Florida Lottery under the terms of the amended contract. Although we intend to vigorously defend and protect AWI's rights under the lottery agreement, we anticipate that AWI may need to renegotiate the Florida Lottery contract on terms that may be less favorable than under the original agreement. Acres In February 1999, the Joint Venture, to which IGT and Anchor are partners, and Anchor filed an action in US District Court, District of Nevada against Acres Gaming, Inc. (Acres). IGT is not a party to this action. The complaint alleges, among other things, infringement of certain secondary event patents owned by Anchor and licensed to the Joint Venture. In April 1999, Acres responded by filing an answer and counterclaim against the Joint Venture and Anchor. In addition, in April 1999, Acres filed an action in Oregon state circuit court against the Joint Venture and Anchor alleging wrongful use of Acres' intellectual property. The Oregon state circuit court action has been removed to the US District Court, District of Oregon, and has been stayed pending the outcome of the Nevada actions. Motions for summary judgment have been filed by the parties. 8. Business Segments At December 29, 2001, Anchor operated principally in three business segments: gaming machines, gaming operations, and gaming systems. The gaming machines segment consists of two business units: the Joint Venture and Anchor Games, which develops and distributes proprietary gaming machines to casinos in exchange for recurring revenue streams. Anchor Games and the Joint Venture activities are viewed as a single business segment because the nature of both product lines is the same. The same management group monitors all activities of our proprietary gaming segment, of which the joint venture is an integral part. Gaming operations are currently conducted through three business units: the Colorado Central Station casino, the Colorado Grande casino and a gaming machine route operation in Nevada. The Montana slot route assets were sold on September 28, 2001, and have been included in the gaming operations segment in the period ended December 31, 2000, and also for the first three months of fiscal 2002. The Company also has a 68% interest in a development contract and seven-year management contract with the Pala Band of Mission Indians to manage a casino in Northern San Diego County, California that opened on April 3, 2001. The Company has agreed to surrender these contracts, subject to conditions (See Note 16). The gaming systems segment consists of three business units. These are AWI, an on-line lottery company; VLC, a company that provides gaming products to government-controlled gaming jurisdictions; and United Tote, a pari-mutuel wagering system company. The following table presents information as to our operations by business segment for the current and comparable prior period. Notes to Condensed Consolidated Financial Statements

December 29, June 30, 2001 2001 ----------------------------------------------------------------------- (in thousands) Identifiable segment assets: Gaming machines $ 125,317 $ 140,709 Gaming operations 106,263 109,451 Gaming systems 138,684 141,654 Corporate 11,679 14,616 --------- --------- $ 381,943 $ 406,430 ========= ========= Notes to Condensed Consolidated Financial Statements 9. Derivatives and Hedging Activities Anchor adopted SFAS No.133, Accounting for Derivative Instruments and Hedging Activities, on July 1, 2000. SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. During October 2001, the Company entered into an interest rate swap agreement designated as a fair value hedge of a portion of our $250 million principal amount of fixed rate debt due in 2008. Under the terms of this agreement, the Company will make payments based on a specific spread over six-month LIBOR, and receive payments equal to the interest rate on the fixed rate debt. The notional value of the swap is $70 million. The interest rate swap agreement qualifies for the "shortcut" method allowed under SFAS No. 133, which allows an assumption of no ineffectiveness in the hedging relationship. As such there is no income statement impact from changes in the fair value of the hedging instruments. Instead, the fair value of the instrument is recorded as an asset or liability on the Company's balance sheet, with an offsetting adjustment to the carrying value of the related debt. Accordingly, the balance of long-term debt has been reduced by $2.6 million and other long-term liabilities reflects the liability associated with the swap. 10. Reclassifications The Company has reclassified the presentation of earnings from unconsolidated joint venture operations. Prior to June 30, 2001, the Company reported earnings from unconsolidated joint ventures as a component of gaming machine revenues. The Company now reports the net results of unconsolidated joint ventures as a separate component of operating income on the income statement under a separate caption titled "Earnings of Unconsolidated Affiliates." Also, due to the adoption of recently issued accounting standards, the Company now recognizes the estimated cost associated with its customer cash rebate loyalty programs as a reduction of revenue. The Company had previously accounted for these amounts in costs of revenues in gaming operations. Certain other amounts in the consolidated condensed financial statements for the three and six months ended December 31, 2000 have been reclassified to be consistent with the presentation used for the three and six months ended December 29, 2001. 11. Recent Accounting Pronouncements During the quarter ended March 31, 2001, the Company adopted Emerging Issues Task Force No. 00-22, Accounting for `Points' and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future. The standard requires that the Company recognize the estimated cost associated with its customer cash rebate loyalty programs as a reduction of revenue. The Company had previously accounted for these amounts in costs of revenues in gaming operations. Prior periods presented have been restated. As a result of the adoption of this standard, the Company reduced revenues $2.0 million and $1.8 million for the quarters ended December 29, 2001 and December 31, 2000, and $3.8 million and $3.7 million for the six month periods ended December 29, 2001 and December 31, 2000. The decreases in revenue were offset by corresponding decreases in costs of revenues; there was no effect on net income. Notes to Condensed Consolidated Financial Statements In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. These statements require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and prohibits the pooling of interest method and changes the accounting for goodwill from an amortization method to an impairment-only approach. The Company is required to adopt the new method of accounting for goodwill and other intangible assets on July 1, 2002. The new method of accounting for goodwill and other intangible assets applies to all existing and future unamortized balances at the time of adoption. The Company has not yet determined the impact of this standard on its results of operations. In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement applies to all entities and applies to all legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and the normal operation of a long-lived asset, except for certain obligations of lessees. This statement is effective for our 2003 fiscal year and early adoption is permitted. We have not yet determined the impact of SFAS No. 143 on our financial position and results of operations. In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment and Disposal of Long-Lived Assets. The changes in this statement require one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. This statement is effective for our 2003 fiscal year, but early adoption is permitted. We have not yet completed our analysis of the impact that SFAS No. 144 will have on our financial condition or results of operations. 12. Subsequent Events On December 30, 2001, IGT completed the previously announced planned merger with Anchor pursuant to which Anchor became a wholly-owned subsidiary of IGT in a stock for stock exchange. Anchor shareholders received one share of IGT common stock for each share of Anchor common stock owned. All rights to purchase shares of Anchor common stock previously granted under Anchor's stock option plans were converted into rights to purchase shares of IGT common stock on the same terms as existed prior to the signing of the merger agreement. The exercise prices of Anchor options assumed by IGT are equal to their original exercise prices. The aggregate purchase price paid for Anchor was approximately $988.4 million, plus the assumption of Anchor's debt of $337.0 million, net of discount. The purchase price includes 14,901,920 outstanding shares of Anchor common stock, which were exchanged for IGT shares valued at $59.50 per share, $93.0 million for Anchor stock options assumed by IGT, $3.7 million of Anchor shares held by IGT prior to the merger, and $5.0 million of estimated transaction costs. The $59.50 share price was determined based on the average closing market prices of IGT's common stock for the seven trading days ended July 12, 2001, which represents the three trading days before and after the merger announcement on July 9, 2001. Notes to Condensed Consolidated Financial Statements The merger will be accounted for as a purchase for financial accounting and reporting purposes. The purchase price will be allocated to Anchor's assets and liabilities based upon the fair values of the assets acquired and liabilities assumed. Goodwill and intangible assets acquired after June 30, 2001, will be subject immediately to SFAS No. 142, which changes the accounting for goodwill and intangible assets with indefinite lives from an amortization method to an impairment-only approach. A portion of the purchase price will be allocated to identifiable intangible assets. Any excess of the cost over the fair values of net tangible and identifiable intangible assets will be recorded as goodwill. Goodwill and intangible assets with indefinite lives acquired will not be amortized. The Company will apply push down accounting for all periods subsequent to December 30, 2001. The merger's consummation on December 30, 2001, triggered the recognition of the following expenses: o An expense of $4.6 million for the immediate vesting of certain restricted stock. Each share of restricted stock became fully vested and unrestricted due to the merger. These shares were canceled and converted into the right to receive IGT common stock. o An expense of $5.5 million related to payment for financial advisory services that was payable on the merger consummation date. All borrowings under our senior unsecured reducing revolving credit facility were repaid on December 31, 2001, in conjunction with the merger. After this payment, the revolving credit facility was terminated. At the close of this transaction, Thomas J. Matthews joined IGT as its Chief Operating Officer, as well as continuing as President and Chief Executive Officer of Anchor. Thomas J. Matthews and Richard Burt, directors of Anchor, became directors of IGT, filling the two newly created seats on the IGT Board of Directors. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Revenues and Gross Margin To conform to the quarterly periods used by IGT, we changed our quarter-end date to the Saturday closest to December 31 in the current quarter. The following table sets forth the percentage of our revenues attributable to each of our operating segments during the three and six month periods ended December 29, 2001 and December 31, 2000. The table also presents the gross margin of each of its operating segments for the same periods.

Three Months Ended December 29, 2001 Compared to Three Months Ended December 31, 2000 Gaming Operations Revenues for this segment were $34.5 million for the quarter ended December 29, 2001, a decrease of $8.6 million from $43.1 million for the same period in the prior year. Excluding Sunland Park Racetrack & Casino (which was sold in December 2000) and the Montana slot route assets (which were sold in September 2001), revenues in this segment increased $4.3 million from $30.2 million to $34.5 million. This increase is primarily due to an increase in fees related to our management, development and guaranty agreements with the Pala Band of Mission Indians, offset by decreased Nevada slot route revenues of $841,000. Colorado casinos revenue was consistent with the prior year. Costs of gaming operations revenues were $19.4 million for the second quarter of fiscal 2002, a decrease of $9.0 million or 32% from $28.4 million in the second quarter of fiscal 2001. Excluding Sunland Park Racetrack & Casino and Montana slot route operations, cost of revenues in this segment increased $648,000, or 3%, from $18.7 million. The increase in cost of revenues primarily relates to the Nevada slot routes. The gaming operations segment gross margin increased to 44% during the quarter ended December 29, 2001 from 34% in the corresponding prior-year period. The increase in gross margin is primarily due to revenue associated with the Pala agreements as well as the sales of the Sunland Park Racetrack & Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Casino and the Montana slot route assets. The two business units that were sold had lower gross margins than the other units in gaming operations. A major competitor, the Hyatt, opened in Black Hawk, Colorado on December 20, 2001. The opening did not have a significant impact during the quarter; however, the additional competition could have a negative effect on our Colorado gaming operations' revenues, margin and profits in the future. Gaming Systems Revenues for this segment were $46.0 million for the quarter ended December 29, 2001, an increase of $4.9 million from $41.1 million for the same period in the prior year. The increase resulted primarily from significant machine sales at VLC to Oregon and a Canadian jurisdiction. VLC revenue increased $5.8 million and was offset by a decrease in revenue at AWI of $1.1 million. Of the decrease at AWI, $500,000 related to domestic revenues and $600,000 related to decreased international revenues. United Tote's pari-mutuel systems revenues increased slightly compared to the prior year. Costs of gaming systems revenues were $29.6 million for the second three months of fiscal 2002, an increase of $378,000 from $29.2 million in the second three months of fiscal 2001. VLC's cost of revenue increased $2.2 million due to the increased sales discussed previously. AWI's cost of revenue decreased $2.2 million, of which $1.2 million related to international business and $926,000 related to domestic business. Cost of revenues for United Tote increased $305,000 for the current period compared to the prior-year period. The gross margin increased from 29% during the quarter ended December 31, 2000 to 36% in the current period. The increase in gross margin is primarily due to the increased sales at VLC. Gaming Machines Revenues for this segment were $11.6 million for the period ended December 29, 2001, a decrease of $2.6 million from $14.2 million for the same period in the prior year. The change consists of a $1.6 million decrease in stand-alone proprietary games revenue and a $1.0 million decrease in machine sales and service. Since December 31, 2000, our installed base of stand-alone games decreased 8% to approximately 3,300 units from approximately 3,600 units. Costs of gaming machine revenues were $5.3 million for the second quarter of fiscal 2002, a decrease of $458,000 compared to the second quarter of fiscal 2001, due primarily to a decrease in expenses related to machine sales and service of $500,000. The gaming machines segment gross margin decreased to 54% during the quarter ended December 29, 2001 from 59% in the corresponding prior-year period primarily due to decreased revenues in the stand-alone proprietary business and a relatively fixed cost structure. Earnings from unconsolidated affiliates increased $1.8 million or 6% from $31.6 million in the quarter ended December 29, 2001 compared to the quarter ended December 31, 2000. At December 29, 2001, there were approximately 16,200 games, primarily Wheel of Fortune(R) and Video Wheel of Fortune(R), operating within the Joint Venture, compared to approximately 14,300 games at December 31, 2000. Changes in interest rates affect the earnings of the Joint Venture. Since jackpot expense is a function of the present value of future jackpot payments, future changes in the interest rate environment will Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations affect the profitability of the Joint Venture. Specifically, decreases in interest rates will increase the jackpot expense of the Joint Venture while increases in interest rates will decrease jackpot expense of the Joint Venture. Other Costs Selling, general and administrative (SG&A) expenses were $19.3 million for the quarter ended December 29, 2001, an increase of $2.3 million or 13% from the quarter ended December 31, 2000. Included in SG&A during the current quarter is $861,000 of expenses related to the merger with IGT and $385,000 of restricted stock compensation, as well as $3.6 million in bad debt expense for receivables associated with Argentina and other South American markets. Included in SG&A in the prior-year quarter is $2.2 million of compensation expense, primarily due to the immediate vesting of a portion of a restricted stock grant. Also included in the prior-year quarter is SG&A of $1.3 million related to Sunland Park Racetrack & Casino and Montana slot route operations. Excluding the items noted above and excluding the operations that have been sold, SG&A increased $912,000. Increases of $429,000 and $633,000 in the gaming machines segment and corporate operations, were partially offset by a $337,000 decrease in the gaming systems segment. SG&A in the gaming operations segment increased slightly during the current year. Research and development (R&D) expenses were $3.1 million for the quarter ended December 29, 2001, a decrease of $317,000 or 9% from the quarter ended December 31, 2000. Each segment decreased slightly compared to the prior-year quarter. Depreciation and amortization expense was $9.8 million for the quarter ended December 29, 2001, a decrease of $5.9 million or 38% from the quarter ended December 31, 2000. The decrease in depreciation and amortization expense over the quarter ended December 31, 2000 is primarily related to the asset impairment recorded in the third quarter of fiscal 2001. Income from Operations As a result of the factors discussed above, income from operations was $39.2 million for the quarter ended December 29, 2001, an increase of $8.6 million or 28%. Other Income (Expense) The $4.6 million increase in other expense for the quarter ended December 29, 2001 as compared to the quarter ended December 31, 2000 is attributable to the effect in the prior year of an $8.1 million gain on the sale of racetrack assets. Offsetting this variance is a decrease in interest expense in the current-year quarter compared to the prior year. The decrease in interest is due to several factors, including: decreased interest on the line of credit because of a decreased balance and lower interest rates; interest on a $66.0 million loan in the prior year associated with the sale of the racetrack assets; and the reduction of interest in the current year in connection with our interest rate swap. These favorable interest expense fluctuations were slightly offset by an increase in interest related to the 9.875% bonds payable which were issued in October 2000 and not outstanding for the full quarter ended December 31, 2000. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Net Income and Earnings per Share As a result of the factors discussed above, net income was $19.4 million for the quarter ended December 29, 2001, an increase of $14.2 million or 272% from the quarter ended December 31, 2000. Diluted earnings per share of $1.24 for the quarter ended December 29, 2001 increased $0.92 or 288% from the quarter ended December 31, 2000. Six Months Ended December 29, 2001 Compared to Six Months Ended December 31, 2000 Gaming Operations Revenues for this segment were $76.4 million for the period ended December 29, 2001, a decrease of $12.6 million from $89.0 million for the same period in the prior year. Excluding Sunland Park Racetrack & Casino and the Montana slot route operations, revenues in this segment increased $10.8 million from $60.2 million to $71.0 million. This increase is primarily due to an increase of $10.5 million in fees related to our management, development and guaranty agreements with the Pala Band of Mission Indians. An increase of $521,000 at the Colorado casinos was partially offset by a decrease in revenues for Anchor Coin. Costs of gaming operations revenues were $43.4 million for the first six months of fiscal 2002, a decrease of $15.1 million or 26% from $58.5 million in the first six months of fiscal 2001. Excluding Sunland Park Racetrack & Casino and the Montana slot route operations, cost of revenues in this segment increased $1.7 million, or 5%, to $39.2 million from $37.5 million. Of the increase, $1.2 million relates to the Nevada slot route business. The gaming operations segment gross margin increased to 43% during the six months ended December 29, 2001 from 34% in the corresponding prior-year period. The increase in gross margin is primarily due to revenue associated with the Pala agreements as well as the sales of the Sunland Park Racetrack & Casino and the Montana slot route assets. These two business units had lower gross margins than the other units in gaming operations. A major competitor, the Hyatt, opened in Black Hawk, Colorado on December 20, 2001. The opening did not have a significant impact on this period; however, the additional competition could have a negative effect on our Colorado gaming operations, revenues, margin and profit in the future. Gaming Systems Revenues for this segment were $92.5 million for the period ended December 29, 2001, an increase of $7.5 million, or 9%, from $85.0 million for the same period in the prior year. Of the increase, $5.6 million is due to an increase in AWI's domestic lottery revenues. The increase was primarily a result of the $295 million Power Ball(R) (Power Ball is a registered trademark of Multi-State Lottery Association) multi-state jackpot in August 2001. This jackpot was the second highest Power Ball(R) jackpot ever. We believe that the large August Power Ball(R) jackpot added approximately $5.8 million in revenue during the first quarter. Within AWI, the domestic revenue increase was partially offset by a $1.1 million decrease in international sales. Increased machine sales at VLC resulted in a $3.2 million increase in revenues for the six months ended December 29, 2001, compared to the same period in the prior year. The increase occurred primarily in the second quarter from significant sales Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations to Oregon and a Canadian jurisdiction. Revenues at United Tote decreased slightly compared to the prior year. Costs of gaming systems revenues were $55.3 million for the first six months of fiscal 2002, a decrease of $4.8 million, or 8%, from $60.1 million in the first six months of fiscal 2001. The decrease is primarily due to a $4.0 million decrease in international lottery costs and a $1.5 million decrease in domestic lottery costs. VLC's cost of revenues increased $514,000 due to the sales discussed previously. Costs of sales at United Tote increased slightly. The gross margin increased from 29% during the six months ended December 31, 2000 to 40% in the current period. The increase is primarily attributable to the increase in domestic revenue at AWI and increased revenue at VLC, as well as the decrease in costs of revenue, both domestic and internationally, at AWI. Gaming Machines Revenues for this segment were $25.9 million for the six months ended December 29, 2001, a decrease of $2.5 million, or 9%, from $28.4 million for the same period in the prior year. Of the decrease, $2.1 million relates to casino sales and service. The remaining decrease relates to our stand-alone proprietary games. Since December 31, 2000, our installed base of stand-alone games decreased 8% to approximately 3,300 units from approximately 3,600 units. Costs of gaming machine revenues were $9.9 million for the six months ended December 29, 2001, a decrease of $1.9 million compared to the same period in fiscal 2001. Of the decrease, $1.0 million related to casino sales and service and the remainder relates to our stand-alone proprietary games. The gaming machines segment gross margin increased to 62% during the six months ended December 29, 2001 from 59% in the corresponding prior-year period primarily due to decreased casino sales which traditionally has a lower gross margin than our stand-alone proprietary business. Earnings from unconsolidated affiliates increased $7.7 million or 12% from $64.7 million in the six months ended December 31, 2000, to $72.4 million in the first half of fiscal 2002. At December 29, 2001, there were approximately 16,200 games, primarily Wheel of Fortune(R), operating within the Joint Venture, compared to approximately 14,300 games at December 31, 2000. Changes in interest rates affect the earnings of the Joint Venture. Since jackpot expense is a function of the present value of future jackpot payments, future changes in the interest rate environment will affect the profitability of the Joint Venture. Specifically, decreases in interest rates will increase the then current period's jackpot expense of the Joint Venture while future increases in interest rates will decrease the then current period's jackpot expense of the Joint Venture. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Other Costs SG&A expenses were $39.2 million for the six months ended December 29, 2001, an increase of $5.4 million or 16% from the six months ended December 31, 2000. Included in SG&A during the current year is $1.9 million of expenses related to the merger, $3.6 million in bad debt expense for receivables associated with Argentina and other South American markets in the systems segment, $1.4 million of bad debt expense in the gaming machines segment, $770,000 of restricted stock compensation, and $500,000 of charitable donations. Included in SG&A in the prior-year period is $2.2 million of compensation expense, primarily due to the immediate vesting of a portion of a restricted stock grant. Also included in the prior-year period and for a portion of the current-year period is SG&A of $1.9 million related to Sunland Park Racetrack & Casino and Montana slot route operations. Excluding the items noted above and excluding the operations that have been sold, SG&A increased $1.3 million. Increases of $776,000 and $785,000 in the gaming machines segment and corporate operations, were partially offset by a $548,000 decrease in SG&A in the gaming systems segment. SG&A in the gaming operations segment increased slightly during the current year. R&D expenses were $6.1 million for the six months ended December 29, 2001, a decrease of $942,000 or 13% from the six months ended December 31, 2000. The decrease is primarily a result of reduced R&D expenses in the gaming systems segment. Depreciation and amortization expense was $20.3 million for the six months ended December 29, 2001, a decrease of $10.4 million or 34% from the six months ended December 31, 2000. The decrease in depreciation and amortization expense over the six months ended December 31, 2000 is primarily related to the asset impairment recorded in the third quarter of fiscal 2001. Income from Operations As a result of the factors discussed above, income from operations was $93.1 million for the six months ended December 29, 2001, an increase of $28.0 million or 43%. Other Income (Expense) The $6.9 million increase in other expense for the six months ended December 29, 2001 as compared to the six months ended December 31, 2000 is attributable to the effect of an $8.1 million gain on the sale of racetrack assets in the prior year, partially offset by a $2.0 million gain recognized in the current year related to the sale of the Montana slot route assets. In addition, interest expense increased $954,000 due to six full months of interest on the 9.875% bonds payable in the current period partially offset by a decrease in line of credit interest, as well as a reduction of interest due to an interest rate swap entered into during the current year. The bonds were issued in October 2000. The decrease in line of credit interest was due to a lower balance and a lower interest rate on the line of credit. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Cumulative Effect of Change in Accounting Principle During the quarter ended September 30, 2000, we adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activity, and recorded an asset related to an interest rate swap as well as a cumulative effect of change in accounting principle in the amount of $124,000, which is net of taxes of $81,000. That interest rate swap was canceled in October 2000. Net Income and Earnings per Share As a result of the factors discussed above, net income was $48.1 million for the six months ended December 29, 2001, an increase of $24.4 million or 103% from the six months ended December 31, 2000. Diluted earnings per share of $3.09 for the six months ended December 29, 2001 increased $1.91 or 162% from the six months ended December 31, 2000. Financial Condition, Liquidity and Capital Resources Capital Resources At December 29, 2001, we had $25.3 million in cash and cash equivalents and $47.3 million in working capital compared with cash and equivalents at June 30, 2001 of $24.1 million and working capital of $17.8 million. All borrowings under our senior unsecured reducing revolving credit facility were paid on December 31, 2001, in conjunction with our merger with IGT. At December 29, 2001, the balance of this facility was $89.5 million. The facility was canceled on December 31, 2001. We believe that cash provided by operations will remain a significant source of cash flows, and anticipate that operations will provide the capital needed for continued business growth. Substantial funds are required for the operation of our gaming systems segment and may also be required for other future projects. The source of funds required to meet our working capital needs (including maintenance capital expenditures) is expected to be cash flow from operations. The source of funds for our future projects may come from cash flow from operations, additional debt or other sources. No assurance can be given that additional financing will be available or that, if available, such financing will be obtainable on favorable terms. Operating Activities During the six months ended December 29, 2001, operating activities provided $75.5 million in cash flows on $48.1 million in net income, compared with $58.9 million in cash flows on $23.7 million in net income during the six months ended December 31, 2000. Net income in the six months ended December 29, 2001 included net non-cash expenses and gains (including depreciation and amortization) of approximately $28.1 million compared with non-cash expenses in the six months ended December 31, 2000 of approximately $26.6 million. Also in the six months ended December 29, 2001, we had cash distributions in excess of earnings in the Joint Venture of $12.7 million, compared to earnings greater than cash distributions in the same six month period in 2000 of $2.6 million. During the six months ended December 29, 2001, changes in working capital resulted in a net cash outflow of $13.4 million compared to a net cash inflow of $11.3 million in the same period of the prior year. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Investing and Financing Activities During the six months ended December 29, 2001, cash outflows for investing activities of $10.3 were a result of the net effect of several activities. Capital expenditures during this period were $17.3 million, of which $10.6 million relates to the gaming machines segment, $2.6 million relates to the gaming operations segment and $3.9 million relates to the gaming systems segment. The remaining capital expenditures were for general corporate purposes. A $4.5 million cash receipt from minority shareholders of one of our consolidated subsidiaries was offset by a note receivable in the same amount, issued by the same subsidiary. Additionally, $6.0 million was received in conjunction with the sale of assets, primarily the Montana slot route assets. Stock Repurchase Program We did not repurchase any shares during the six months ended December 29, 2001. Liquidated Damages Under On-line Lottery Contracts Our lottery contracts typically permit termination of the contract by the lottery authority at any time for our failure to perform or for other specified reasons and generally contain demanding implementation schedules and performance schedules. Failure to perform under such contracts may result in substantial monetary liquidated damages, as well as contract termination. Many of our lottery contracts also permit the lottery authority to terminate the contract at will and do not specify the compensation, if any, to which we would be entitled should such termination occur. Some of our United States lottery contracts have contained provisions for up to $1.0 million a day in liquidated damages for late system start-up and have provided for up to $15,000 per minute or more in penalties for system downtime in excess of a stipulated grace period, and some of our international customers similarly reserve the right to assess monetary damages in the event of contract termination or breach. Although such liquidated damages provisions are customary in the lottery industry and the actual liquidated damages imposed are generally subject to negotiation, such provisions in our lottery contracts present an ongoing potential for substantial expense. In July 2001, we reached an agreement with the Florida State Lottery and settled all outstanding issues related to liquidated damages associated with the system conversion. In conjunction with this settlement, AWI paid $4.5 million in July 2001 to the Florida State Lottery. Our lottery contracts generally require us to post a performance bond, which in some cases may be substantial, securing our performance under such contracts. Recently Issued Accounting Standards During the quarter ended March 31, 2001, we adopted Emerging Issues Task Force No. 00-22, Accounting for `Points' and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future. The standard requires that we recognize the estimated cost associated with its customer cash rebate loyalty programs as a reduction of revenue. We have previously accounted for these amounts in costs of revenues in gaming operations. Prior periods presented have been restated. As a result of the adoption of this standard, the Company reduced revenues $2.0 million and $1.8 million for the quarters ended December 29, 2001 and December 31, 2000, and $3.8 million and $3.7 million for the six month periods ended Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations December 29, 2001 and December 31, 2000. The decreases in revenue were offset by corresponding decreases in costs of revenues; there was no effect on net income. In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. These statements require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and prohibits the pooling of interest method and changes the accounting for goodwill from an amortization method to an impairment-only approach. We are required to adopt the new method of accounting for goodwill and other intangible assets on July 1, 2002. The new method of accounting for goodwill and other intangible assets applies to all existing and future unamortized balances at the time of adoption. We have not yet determined the impact of this standard on its results of operations. In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement applies to all entities and applies to all legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and the normal operation of a long-lived asset, except for certain obligations of lessees. This statement is effective for our 2003 fiscal year and early adoption is permitted. We have not yet determined the impact of SFAS No. 143 on our financial position and results of operations. In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment and Disposal of Long-Lived Assets. The changes in this statement require one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. This statement is effective for our 2003 fiscal year, but early adoption is permitted. We have not yet completed our analysis of the impact that SFAS No. 144 will have on our financial condition or results of operations. Risk Factors and Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995 This report contains "forward-looking" statements, which are not historical facts, but are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to analyses and other information based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to our future prospects and proposed new products, services, developments or business strategies. These forward-looking statements are identified by their use of terms and phrases such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "predict," "project," "will," "continue," and other similar terms and phrases, including references to assumptions. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent known and unknown risks and uncertainties. We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances. Specific risks and uncertainties of which you should be aware include, but are not limited to, the following: o any unfavorable change in IGT's relationship with third parties resulting from the merger may reduce our post-merger profits; o IGT may have difficulty integrating parts of our operations; o our success depends in part on our ability to retain key personnel after the merger; o the accounting treatment of the merger will result in future non-cash charges to our operations; o our pro forma accounting for the merger reflected in our public filings may change; o we and our subsidiaries remain subject to covenant restrictions in our indenture; o our lottery business could subject us to significant liquidated damages claims, which would adversely affect our operating results; o the risk that we may not meet our projected financial results for fiscal 2002; o we are subject to risks of proprietary games such as pressures from competitors, changes in economic conditions, obsolescence, declining popularity of existing games, failure of new game ideas or concepts to become popular, duplication by third parties and changes in interest rates as they relate to the wide area progressive machine operations within our joint venture with IGT; o we are subject to general changes in economic conditions; o we may not be able to achieve the cost reductions associated with the restructuring of our gaming systems segment; o we may not be able to keep or renew existing lottery contracts; o competition in Colorado could adversely affect our Colorado casinos; o we may not be able to generate sales of new video lottery central control systems and video lottery terminals; o we are subject to adverse determination in pending litigation with Acres Gaming relative to our proprietary games intellectual property; o we are subject to adverse determination in pending litigation between Gtech Holdings and the Florida Lottery relative to our Florida lottery contract; and o we have obligations under agreements with the Pala Band of Mission Indians that subject us to joint venture risk and sovereign immunity risk. Item 3. Quantitative and Qualitative Disclosure about Market Risk Market Risk Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates and commodity prices. Our primary exposure to market risk is interest rate risk associated with our long-term debt and our investment in the Joint Venture. Interest Rate Risk The principal balance of our floating rate debt at December 29, 2001, was $89.5 million. In June 1999, we entered into a $300.0 million unsecured revolving credit facility (Credit Facility) expiring June 30, 2004. Our Credit Facility was amended in October 2000 and the availability under our facility was increased to $325.0 million. On December 31, 2001, the balance on our line of credit was paid in conjunction with our merger with IGT. The line of credit was canceled at that time. To reduce the risks of changing interest rates, we selectively use hedging instruments. We attempt to limit our exposure to interest rate risk by managing the mix of our fixed rate and floating rate borrowings. During October 2001, we entered into an interest rate swap agreement designated as a fair value hedge of a portion of our $250 million principal amount of fixed rate debt due in 2008. Under the terms of this agreement, we will make payments based on a specific spread over six-month LIBOR, and receive payments equal to the interest rate on the fixed rate debt. The notional value of the swap is $70 million and the estimated fair value of the liability is $2.6 million. The profitability of our investment in the Joint Venture is also affected by changes in interest rates. The Joint Venture records expenses for future jackpots based on current rates for government securities and bank debt instruments of varying maturities, which are used to fund liabilities to winners. As interest rates decline, our equity in the earnings of the Joint Venture also decline. A 10% decline in interest rates would have impacted the earnings of the Joint Venture by $1.5 million in the three months ended December 29, 2001. Foreign Currency Risk We do not have any cash or cash equivalents at December 29, 2001 that are subject to market risk based upon changes in interest rates. We are exposed to the risk of foreign currency exchange rate fluctuations. As of December 29, 2001, we had accounts and notes receivable denominated in Canadian dollars of $1.3 million and $621,000 denominated in Australian dollars. All foreign receivables are expected to be collected within 12 months. We do not currently hedge against foreign currency exposure. Part II. Other Information Item 1. Legal Proceedings For a description of our legal proceedings, see Note 7 to our consolidated financial statements, which is incorporated by reference in response to this item. In addition to the specific legal proceedings described in Note 7, we are a party to several routine lawsuits arising from normal operations. We do not believe that the outcome of such litigation will have a material adverse effect on our consolidated financial statements. Item 2. Changes in Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders On December 18, 2001, we held a special meeting of stockholders to approve the merger with IGT. Voting at the meeting was as follows: For Against Abstain Broker Non-Votes --- ------- ------- ---------------- 11,620,869 91,739 38,228 3,158,422 Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Reports on Form 8-K Current Report on Form 8-K dated December 26, 2001 announcing we had entered into an agreement with the Pala Band of Mission Indians and Jerome H. Turk. (b) Exhibits None SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, we have duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized. ANCHOR GAMING (Registrant) Date February 12, 2002 By: /s/ Thomas J. Matthews ------------------------------------- Thomas J. Matthews Chief Executive Officer and President Date February 12, 2002 By: /s/Daniel R. Siciliano ------------------------------------- Daniel R. Siciliano Principal Accounting Officer and Corporate Controller

ANCHOR GAMING 10-Q