Monday, February 13, 2006

PokerTek, Inc.--Dealt a Bad Hand? Fold!

The World Series of Poker on ESPN, The World Poker Tour on the Travel Channel, Celebrity Poker Showdown on Bravo, Poker Royale on the GSN (formerly the Game Show Network), and the Hollywood Hold'em series which aired on the E! channel—the growth of tournament poker dominated the TV landscape, as seen by an unending stream of programming on these and other TV networks last year.

The American Gaming Association reports that nearly one in five American adults played poker during the last 12 months, a more than 50 percent increase from the previous year. Consumer spending on poker has increased dramatically, too. Additionally, the American Gaming Association reports that in Nevada and New Jersey (the only states that track poker revenue) poker players spent $151.7 million on organized poker in 2004, a 45% increase over 2003.

According to Casino City Press, as of June 2005, there were approximately 3,900 poker tables operating in the United States and close to 2,000 outside the United States. And, According to the Tribal Court Clearinghouse, of the 562 Federally-recognized Native American tribes, 224 were engaged in gaming, operating an aggregate of approximately 1,245 tables in 28 states.

The commercial casino segment of the poker market is the most mature and is almost as large as the tribal casino segment. The American Gaming Association reports that there were 445 casinos operating in the 11 states that offer legalized gaming in 2004. The largest market for commercial casinos was Nevada, which in 2004 had 258 casinos, and New Jersey, which in 2004 had 12 casinos. According to Casino City Press, commercial casinos operate approximately 1,210 poker tables in the United States.

Seeking to cash in on the poker craze, PokerTek, Inc. (PTEK-$11.00) was formed to develop and market the PokerPro system, an electronic poker table that provides a fully-automated poker-room environment, to tribal casinos, commercial casinos and card clubs. The computer-operated table game allows as many as 10 people to play Texas Hold 'Em. The two-year old Company offered approximately 22% of its equity with a two million share IPO on October 14, 2005, at $11.00 per share.

The gaming technology firm’s shares fell 8 percent, closing at $10.15 per share on its first day of trading.

In our opinion, like the ratings of some of the aforementioned programs, this stock has much further to fall.

The PokerPro system is designed to increase casino revenue and security while helping to reduce the labor costs associated with poker rooms. The Company’s limited testing of the PokerPro system has shown that by eliminating a live dealer, more hands of poker can be played in a given amount of time, thereby increasing revenue generated by the “rake.” The rake is the amount a casino or card club charges for each hand of poker. In addition, the elimination of a live dealer allows casinos and card clubs to avoid the labor costs of using a live dealer to operate a poker table.

The Company generates revenue from licensing the rights to use the software necessary to operate the PokerPro system, from providing maintenance and support services to customers that license the PokerPro system, and from sales of equipment. Looking at operational results for the three-month period ended September 30, 2005, the company reported a net loss of $2.5 million, or $(0.35) per share. The agreement with the Seminole Tribe of Florida was entered into on a month-to-month basis. Revenue from licensee fees was $42,000 along with $5,360 in equipment sales during the quarter.

The monthly cash burn rate for the third quarter was approximately $307,000--principally for salaries, professional services, marketing, office expenses and the purchase of the hardware components for PokerPro systems. As a result of expected growth, management anticipates this rising to $500,000-to-$750,000 in the New Year.

Corporate intent is to a build a presence for the PokerPro system in tribal casinos first, as the regulatory requirements for manufacturing and distributing gaming machines to tribal casinos are the least burdensome.

After installing tables at its Hollywood, Fla., Seminole Hard Rock Hotel and Casino earlier this year, the Seminole Tribe has installed PokerPro tables at a second facility, too, the Seminole Hard Rock Hotel and Casino in Tampa, Fla.

In addition to the four PokerPro tables at its Winstar Casino, the Chickasaw Tribe of Oklahoma recently installed PokerPro tables at two additional casinos and has ordered tables for its fourth casino. With this installation, which was scheduled for early December, PokerTek will have a total installed base of 21 PokerPro tables. That, however, is the only good news that we could unearth on the Company.

To implement its business plan and generate revenue from other sources, management must obtain regulatory approvals in additional jurisdictions. Obtaining these requisite approvals is a time-consuming and costly process.

In a three-month period, we estimate that these 21 PokerPro tables could generate approximately $300,000 in fees. Sadly, approximately fifty cents on every dollar will go towards paying the base salaries of the top five insiders (this figure excludes stock compensation expenses and any “salary” paid to Lyle Berman, for his role as the titular Chairman).

While we are on the subject of executive perquisites—Chairman Lyle Berman was granted an option to purchase 200,000 shares of common stock when he was appointed to the Board of Directors in January 2005. “Chairman Mao” and other early shareholders—who collectively own approximately 78%, or 7.3 million shares—paid an average price of $0.07 per share. Insiders also hold exercisable options to purchase an additional 216,825 shares of common stock at an average weighted price of $2.67 per share.

Henry David Thoreau wrote: “It is a characteristic of wisdom not to do desperate things.” In June 2004, withering and in desperate need of funding, PokerTek executed an unsecured promissory note with World Poker Tour for approximately $185,000. In consideration for the Note given to the Company, the Company issued 1,080,000 shares of common stock to WPT. As part of the transaction with WPT, the Company received a 10-year royalty-free license to use the “World Poker Tour” name and related logo and trademark in the United States within the commercial poker table market. Nonetheless, management of PokerTek left $11.9 million on the table—all for the untested goodwill of a trademark and pennies in funding. Not a good poker move.

Commercial casinos could be a lucrative market opportunity for the Company. For now, however, corporate will not offer the PokerPro system to this business segment. There are two reasons for this intended delay: (1) Regulatory approval for commercial casinos could take up to 24 months or longer. (2) To date, gaming authorities have determined that only PokerTek’s Chairman, Lyle Berman, is suitable to lease, license or sell the Company’s PokerPro system Lyle Berman is also the CEO of Lakes Entertainment, Inc. (LACO), a Minnesota-based publicly traded company whose primary business is managing tribal casinos, and Executive Chairman of WPT Enterprises, Inc. (WPTE), the operator of the World Poker Tour.

It is no secret that corporate is highly dependent on Mr. Berman for top-line growth. Of the top six executives in the Company, only Mr. Berman has a gaming background. As such, the Company will be looking to develop business relationships from introductions to strategic partners in the gaming industry that we Mr. Berman could facilitate. However, Mr. Berman is under no obligation to facilitate such introductions. Mr. Berman is 62 years old, and his health status is unknown.

On a related note-- Gehrig “Lou” White, CEO, and a director and holder of approximately 25% of PokerTek’s common stock, has disclosed that the IRS had challenged the tax treatment of his 2001 filing. Specifically Mr. White anticipates that the IRS will issue a notice of deficiency that assesses additional income taxes as the result of disallowing deductions for tax advice in connection with a partnership investment transaction and an accuracy penalty in connection with the losses claimed with respect to that investment. According to SEC filings, due to the broad discretionary powers of gaming authorities, it is unknown what effect the IRS examinations of Mr. White’s federal income tax returns may have on Mr. White’s applications for a determination of suitability.

On April 28, 2005, filed an application with the U.S. Patent and Trademark Office to register the PokerPro trademark. The application is pending.

The Company currently has applications for 27 patents pending before the U.S. Patent and Trademark Office, which relate to various aspects of the PokerPro system. However, patent applications can take many years to issue and management can provide no assurance that any of these patents will be issued at all. We only mention this at all because there are limited barriers to entry in the Company’s market(s), and third party infringement of intellectual property rights would likely require substantial financial resources.

And speaking of intellectual property rights—a key component of the PokerPro gaming system architecture is licensed from a third party, Standing Stone Gaming, an operating unit of the NY Oneida Indian Nation, for its Oneida II Lite software. The Oneida OII account-based gaming system utilizes cashless, personal identification cards, making it easier for the casino(s) to gather critical marketing information—such as names, wagering amounts, and preferred games and frequency of visits—to create successful promotions and activities.

This is a NON-EXCLUSIVE SOFTWARE LICENSE AGREEMENT and PokerTek must pay to SSG the sum of $25,000 for each initial integration of the SSG Licensed Software. Due to the limited barriers to entry, the 10Q Detective believes that it is highly likely that a company with greater resources—like an International Game Technology (IGT)—could easily supplant the PokerPro system with directly competitive products.

PokerTek’s inability to enter into anything more than month-to-month licensing agreements, questionable market acceptance of the PokerPro system itself, and an inexperienced management team—all these variables make for a less-than visible revenue stream.

In the opinion of the 10Q Detective, the stock price of PokerTek has no material catalyst for an upside move. Come April 2006, the lock-up agreements on millions of common stock held by company insiders—including employees, their friends and family, and venture capitalists— will expire. Expiration of these lockup agreements will be the first time in the PokerTek’s public life that insiders could start to sell their shares in the open market, subject to Rule 144 restrictions.

One restriction is that sales over a three-month period cannot be greater than the average weekly trading volume of the common stock during the four calendar weeks preceding the sale. The average daily trading volume of PokerTek’s stock has been approximately 24,000 shares over the last three months. Insiders own millions of shares at an average cost price of $0.07 per share. Such an infusion of shares into the market by these investors could potentially have a negative impact on PokerTek’s stock price for months to come.

This being the Poker(tel) hand dealt, we recommend folding.

2 comments:

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Anonymous said...

What do you make of PTEK's activity this week? On Tuesday, it was trading below $12. By Thursday, it had closed at $15.11!

Looks like a decent candidate to short.

Any thoughts?