We are a diversified provider of technology and pari-mutuel horse racing content for consumers through Internet and telephone platforms and a leading supplier of totalizator systems, terminals and other pari-mutuel wagering services and systems to the pari-mutuel industry. Youbet is a leading licensed and legal online advance deposit wagering, or ADW, company focused on horse racing primarily in the U.S. Through our International Racing Group subsidiaries, IRG U.S. Holdings Corp., IRG Holdings Curacao, N.V., International Racing Group N.V., and IRG Services, Inc. (collectively, IRG), we are the only off-shore pari-mutuel rebate providers to be licensed by a U.S. racing regulatory jurisdiction. Through our United Tote subsidiaries, UT Gaming, Inc., United Tote Company and United Tote Canada (collectively, United Tote), we are a leading provider of totalizators and related services.
Our operations are organized and managed by product type. We currently operate in two segments of the pari-mutuel horse racing industry: ADW and Totalizator Services. The ADW segment consists of the combined operations of Youbet and IRG focusing in on-line and telephone platform wagering. The Totalizator Services segment consists of the United Tote operations pertaining to the providing of totalizator equipment and services to tracks and other venues. For more information regarding the revenues, operating profits and identifiable assets attributable to our operating segments, see Note 12 to our consolidated financial statements at the end of this report.
Based on information compiled by the International Federation of Horseracing Authorities, over 80% of pari-mutuel wagers, or handle, on thoroughbred racing in the U.S. were placed at locations away from the host track. We believe the shift towards off-track wagering has been driven by the betting public’s desire for convenience and access to a broader range of content. Our website, www.youbet.com , and our interactive voice recognition telephonic system, enable our customers to securely wager on horse races at over 150 race tracks worldwide from the convenience of their homes or other locations. Our customers receive the same odds and expected payouts they would receive if they were wagering directly at the host track and wagers are placed directly into the track betting pools.
We strive to appeal to both new and experienced handicappers by providing a user-friendly “one-stop-shop” experience. To place a wager, customers open an account and deposit funds with us via several convenient options, including our ExpressCash system, which links our customers’ wagering accounts directly to their personal checking accounts. To enable our customers to make informed wagers, we provide 24-hour access to up-to-the minute track information, real-time odds and value-added handicapping products, such as Turfday Super Stats, a comprehensive database of racing statistics and a grading system to assess trainers, jockeys and horses. Our customers can view high-quality, live audio/video broadcasts of races as well as replays of a horse’s past races. Our convenient automated services are complemented by our player service agents, who are available 15 hours a day, seven days a week to provide technical support and address any wagering or funding questions.
Our content partners provide us the same live satellite feeds that they normally broadcast at the track and to the off-track betting facilities, or OTBs. As a result, our partners have the opportunity to increase the total handle wagered on their racing signal, which we believe leads to higher revenues for the host track and a higher quality of racing through larger purses for the horse owners. In return, we receive a commission, or a percentage of their wager (handle), from the race tracks.
We were incorporated in Delaware on November 13, 1995. Our executive offices are located at 5901 De Soto Avenue, Woodland Hills, California 91367 and our telephone number is (818) 668-2100. Our website address is www.youbet.com .
Industry Overview
In 2006, global pari-mutuel horse racing handle was estimated at approximately $91 billion, of which over 80% was wagered off-track according to the International Federation of Horseracing Authorities. According to The Jockey Club, total U.S. handle on thoroughbred racing, the most popular type of horse racing, was estimated at approximately $15 billion in 2006, of which 88% was wagered away from the host track, such as at OTBs, at other tracks, or via Internet and telephone wagering. Between 1994 and 2006, U.S. handle on thoroughbred racing increased at an approximate 3.6% compound annual growth rate. We believe that the ADW segment has outpaced overall pari-mutuel industry growth in recent years and that the largest volume of ADW wagers in the U.S. were processed through entities licensed as multi-jurisdictional wagering hubs in Oregon. According to the Oregon Racing Commission, handle processed through multi-jurisdictional wagering hubs based in Oregon and California increased 4.9% from approximately $0.9 billion during the nine months ended September 30, 2005, to approximately $1.3 billion during the similar period in 2006. We believe such growth was driven by technological innovations facilitating secure and convenient remote access to a wide range of horse racing events which has broadened the market for the distribution of live racing products.
In 2000, the United States Congress amended the Interstate Horseracing Act of 1978 to clarify the legality of wagering via telephone or other electronic media and the commingling of pari-mutuel wagering pools.
In the fourth quarter of 2006, Congress passed the Unlawful Internet Gambling Enforcement Act of 2006 (the Act), which includes certain racing protective provisions by maintaining the status-quo with respect to wagering activities covered under the Interstate Horseracing Act of 1978, as amended. The Act prohibits the acceptance of credit cards, electronic funds transfers, checks, or the proceeds of other financial transactions by persons engaged in unlawful betting or wagering businesses. The Act specifically excludes from the definition of unlawful Internet gambling “any activity that is allowed under the Interstate Horseracing Act of 1978”.
Competitive Advantages
We are a leading ADW company focused on horse racing primarily in the U.S., and have processed over $1.8 billion in wagers from January 1, 2002 to December 31, 2006. We have been able to achieve this by leveraging the following competitive advantages:
Diverse content offering
We believe that we offer the most in-depth and diverse supply of real-time content in the ADW segment with over 150 race tracks in the U.S., the U.K., Canada, Japan, Australia, South Africa and Hong Kong. As a result, customers can view and wager on their choice of over 15 hours of live thoroughbred, harness and quarter-horse racing on weekdays and Sundays and nearly continuous 24-hour horse racing on Saturdays. Our content licensing agreements with Television Games Network, or TVG, a subsidiary of ODS Technologies, L.P. and ODS Properties, Inc., which are subsidiaries of Gemstar — TV Guide International, Magna Entertainment Corporation, which we refer to as Magna, and approximately 150 race tracks throughout the world permit us to broadcast the racing content from popular venues such as Churchill Downs, Hollywood Park, Del Mar Thoroughbred Club, Santa Anita Park and Gulfstream Park and for marquee events such as the Kentucky Derby, the Preakness, Belmont Stakes, and the Breeders’ Cup.
Extensive customer database and strong analytical capability
The handle processed through our wagering platforms increased 61.5% from $472 million in 2005 to $763 million in 2006. We have been able to achieve much of this growth through the use of our sophisticated data mining software, which generates detailed customer segmentation analyses based on variables such as wagering propensities and preferences. With this information, we are able to personalize our product offerings through targeted special offers, contests and promotions tailored to specific customer segments. This information also helps us maximize revenue yield by allowing us to target promotions and incentives to wager on tracks that generate greater revenue yield to us.
Highly scalable infrastructure
Our highly scalable technological infrastructure and automated online and telephonic wagering platform provide us with significant operating leverage. We typically operate at less than 33% of system capacity. This built-in excess capacity enables us to easily process significantly greater wagering volume at a low incremental cost. Additionally, we continuously build automation into our core online and interactive voice recognition wagering platform in order to minimize our incremental staffing requirements. With this operating leverage, we are well-positioned to capitalize on handle growth to increase earnings.
Expanded opportunities with the acquisition of IRG, United Tote and Bruen Productions
Our acquisition of IRG in June 2005 diversified our customer base and increased our handle. With handle and gross revenues of $299 million and $22 million in 2006, IRG provides us with an established market position in the rapidly growing rebate provider sector, utilized by high-volume customers that expect rebates from their provider. The rebate model encourages high-volume wagering by providing qualifying customers with a pre-determined percentage rebate (credit to the customer’s account) based on the total amount wagered. In addition, this acquisition also allows us to expand our customer base with live telephone operators. IRG was recently issued a one-year license to operate a multi-jurisdictional simulcasting and interactive wagering hub by the Oregon Racing Commission.
Our acquisition of United Tote in February 2006 provides for increased diversification of our customer base and product offering as well as furthers our efforts to be the pari-mutuel industry’s leading end-to-end technology provider. United Tote processes more than $7 billion in handle annually on a global basis, approximately 90% of which is North American pari-mutuel handle. United Tote supplies pari-mutuel tote services to approximately 94 racing facilities in North America and 11 facilities in Korea, Mexico, Spain and other foreign markets.
On October 9, 2006, Youbet acquired privately-held Bruen Productions International, Inc. (Bruen Productions), a full-service broadcast production company. Bruen Productions specializes in the creation of marketing and advertising campaigns which leverage their broadcast and internet audio/visual capabilities, pod cast production and consulting experience, and direct response marketing expertise including WEBmercial production. Youbet now has the ability to produce creative content that can benefit its core offerings and reduce operating costs in this area. Established in 1983, Bruen Productions serves clients in the U.S. and Canada.
Rigorous compliance and controls
In February 2005, to ensure ongoing use of “best practices” in our internal pari-mutuel wagering controls, we established an independent wagering compliance committee. This committee, currently comprised of experienced professionals in law enforcement, security and gaming, provides ongoing oversight and review of our compliance procedures and policies. The committee meets periodically and reports its findings and recommendations to independent members of our Board of Directors.
Growth Strategies
We aim to maintain our market-leading position in the ADW segment while we continue to diversify our product offerings and build upon the strength of our brand. We intend to increase handle and expand our business, and we have adopted the following key growth strategies to achieve this objective:
Continue to develop high-quality wagering products
We intend to continue to develop industry-leading technology and to expand the diversity and breadth of our product offerings and services. We believe this will translate into a more enjoyable customer experience, and as a result, we believe our customers will place a greater portion of their wagering dollars through us. In September 2004, we launched our next generation automated interactive voice recognition system, Youbet Mobile, to capture a greater share of the ADW handle currently wagered telephonically. We launched our Youbet Mobile website in December 2005. In January 2007, we launched KingContest.com, a new Internet game site where contestants can enter skill-based contests for a fee and then compete to win a wide variety of prizes. KingContest.com is our first pay-to-play fantasy skill website and our first entry in the growing online game/contest market.
Focus on targeted marketing
We intend to increase our focus on attracting new customers and driving traffic to our wagering platforms by leveraging our proprietary internet portals (i.e. Youbet.net and Kingcontest.com) and our existing marketing relationships with CBS SportsLine.com and ESPN.com, in addition to developing relationships with other potential Internet portals. Through these agreements, we are able to promote the Youbet brand and cost-effectively direct traffic to our wagering platforms, while providing our marketing partners with access to handicapping information and our live racing content.
Seek acquisition opportunities
We intend to seek additional acquisition opportunities in the U.S. and abroad to leverage our highly scalable online and telephonic wagering platforms and to diversify our customer base, revenue streams and content. Domestically, opportunities may exist to grow handle and increase market share by targeting companies in the fragmented ADW and rebate provider sectors. We also plan to target companies which provide strategic infrastructure components in order to become more vertically integrated and to diversify our product offerings and customer base. Internationally, we believe opportunities exist to increase our market presence and to offer different forms of wagering while simultaneously providing our customers with a more diverse array of content to view and upon which to wager.
Expand international presence
Global pari-mutuel horse racing handle is estimated at approximately $91 billion, according to the International Federation of Horseracing Authorities. In 2006, we derived less than 4% of our handle from races outside of the U.S. and Canada. We hope to increase our penetration of the international market by entering into content and equipment sales and servicing (via our United Tote operations) agreements with leading international tracks. This will enable us to expand our customer base internationally, while simultaneously providing our domestic customers with a more diverse array of content to view and to wager upon. In addition, international jurisdictions permit a broader array of wagering activities than the U.S., including fixed-odds sports betting. With modifications, our robust operating platform can be adapted to facilitate such international opportunities.
Leverage our flexible wagering platform to provide online solutions for track operators and other gaming companies
Only a limited number of track operators currently operate a website that accepts ADW wagers. If track operators or other gaming companies decide to enter the online ADW segment, our experience and technological leadership make us highly qualified to assist in building and supporting such websites. In addition, with our technologically advanced, highly scalable and flexible online platform and our excess capacity, we are well-positioned to provide the technological infrastructure for the online initiatives of track operators or other gaming companies.
Revenue Sources
Pari-mutuel racetrack operators typically retain a portion of all wagers as their commission prior to distributing payoffs to the winners. In accordance with our arrangements with TVG, Magna, and independent racetracks, we receive a commission from each racetrack calculated as a percentage of our customers’ wagers that are delivered to their respective pari-mutuel pools. In the aggregate, these commissions represent over 81% of our ADW revenues for 2006. We generate additional revenue primarily from processing fees, monthly subscription fees and the sale of handicapping information.
Revenue is additionally derived from contractual arrangements for the installation and maintenance services of totalizator systems at numerous horse racing facilities. This revenue is supplemented by sales of the supplies used by the terminals.
As of December 31, 2006, TVG exclusive tracks and racing associations consisted of Aqueduct, Belmont Park, Calder Race Course, Churchill Downs, Del Mar, Ellis Park, Emerald Downs, Fairplex Park, Hollywood Park, Hoosier Park, Keeneland, Los Alamitos, Oak Tree, Prairie Meadows, Ruidoso Downs, Saratoga, Turf Paradise, and Turfway Park, and TVG non-exclusive tracks covered by the license and content agreement for 2006 and 2007 consisted of Bay Meadows, Cal Expo, Mountaineer, and Oaklawn.
In December 2006, we negotiated the financial terms of a new content license agreement with Magna. Magna owns and operates several horse racing and pari-mutuel wagering facilities throughout North America, including Santa Anita Park and Golden Gate Fields in California, Gulfstream Park in Miami, Florida, and Laurel Park and Pimlico Racecourse in Maryland.
Marketing
Using various media channels such as Youbet Express SM , the Internet, print advertising, radio, and brand placement, we focus our integrated marketing efforts on both casual and serious horse racing enthusiasts. An integrated marketing approach allows us to cycle a series of targeted messages centered on product features and benefits, online tournaments and contests, and event-specific promotions.
Our ongoing marketing campaigns and customer retention strategies are supported with customer research and analysis and are intended to satisfy the needs of existing customers and drive new customers to Youbet Express SM . We frequently initiate communication with our customers via phone and e-mail. One-on-one messaging through the Youbet Express SM homepage allows us to tailor personalized messages and offers to our members based on their wagering propensity and preferences.
In May 2005, we announced that we signed an agreement to be the exclusive horse racing content provider for CBS SportsLine.com, a leading Internet sports media organization. This deal means that our diverse content offering — including live racing video, race replays, handicapping products, racing tutorials, and games and contests — are now accessible to the millions of sports fans who visit CBS SportsLine.com’s flagship website, www.cbs.sportsline.com , each and every month.
In May 2005, we announced that we are combining forces with legendary trainer D. Wayne Lukas to launch a new website devoted to the career of the legendary trainer. The new website , www.dwlukas.com , features weekly commentary on the racing scene, chronologies on the storied trainer’s career, updated photos and a section called “Derby Trail” that gives insight to Lukas’ views on his Triple Crown entrants. Content will be expanded over time to include other major event news and views.
Business Development
Acquisition of United Tote
On February 10, 2006, we completed our acquisition of United Tote for $31.9 million plus the assumption of approximately $14.7 million of United Tote debt (primarily related to the financing of equipment that is placed with United Tote’s track customers). We financed the acquisition by delivering to UT Group, LLC, United Tote’s former owner, the following consideration:
| • | Approximately $9.7 million in cash; |
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| • | $5.2 million one-year, unsecured promissory note; |
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| • | $3.2 million two-year, unsecured promissory note; |
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| • | $1.8 million two-year, unsecured promissory note; and |
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| • | 2,181,818 shares of Youbet common stock, valued at $5.50 per share. |
For more information regarding these promissory notes and our refinancing of United Tote’s debt, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations, Contingent Liabilities and Commitments.”
Acquisition of Bruen Productions
On October 9, 2006, Youbet acquired privately-held Bruen Productions. We financed the acquisition with the issuance of $162,000 in common stock held in treasury, payable in four installments over the next three years and the assumption of approximately $173,000 of debt. Youbet delivered 13,953 shares of common stock in October 2006 as the first installment.
Competition
Web-based interactive gaming and wagering is a new and rapidly changing marketplace. We anticipate competition will become more intense as many web-based ventures focus on the gaming industry. Management believes that we are well-positioned to compete with these entities, as well as other established gaming companies seeking to enter the interactive, pari-mutuel gaming market.
The Television Games Network TM , operated by TVG, is a direct competitor in the domestic interactive pari-mutuel gaming market and currently accepts wagers from customers living in twelve states. The Television Games Network is a 24-hour national horse racing channel broadcast over cable and satellite. Customers receive a dedicated television set-top box linked to the Television Games Network’s pari-mutuel wagering system. The Television Games Network’s web-based wagering product was launched in 2000. The Television Games Network has formed exclusive relationships with a number of major U.S. horse tracks to broadcast their events.
In 2002, Magna introduced XpressBet TM , an online wagering platform which allows customers to place wagers online throughout North America.
On March 5, 2007, Magna and Churchill Downs announced that they had formed a joint venture through which each company’s respective horse racing content will be made available to third parties and each company’s respective ADW platform, including XpressBet™ and www.twinspires.com, an ADW platform owned by Churchill Downs that is currently under construction. Additionally, Churchill Downs also purchased a 50 percent stake in Horse Racing TV, which is owned by Magna. While we expect to continue to have access to content provided by Magna and Churchill Downs and believe that the joint venture’s stated emphasis on broader distribution of racing content bodes well for our non-exclusive business model, it is too early to predict how this joint venture will impact our ADW segment or our business overall.
We also consider several other companies offering interactive wagering to residents of the U.S. to be viable competitors. One such company, Winticket.com owned by AmericaTAB, has formed non-exclusive relationships with many of the same tracks we offer. Other competitors include The Racing Channel, doing business as Oneclickbetting.com.
In our totalizator equipment sales and servicing business, we compete primarily on the basis of the design, performance, reliability and pricing of our products as well as contract services provided. To effectively compete, we expect to make continued investments in product development and/or acquisitions of technology. Our two principal competitors in this business segment are AmTote International, Inc. (owned by Magna) and Scientific Games Corporation. Our competition outside of North America is more fragmented, with competition also being provided by several international and regional companies.
We believe potential new domestic and international competitors looking to enter the interactive wagering marketplace may include large established interactive and online software companies, media companies and gaming companies. Our business strategies may be influenced by the timing of a competitor’s product releases and the similarity of such products to our products. Additional competition may result in significant pressure on our pricing and profit margins.
Government Regulation and Legislation
Current licensing
In November 2006, the State of California Horse Racing Board renewed both of our in-state and out-of-state ADW licenses through the end of 2007. Terms for these one-year licenses began on January 1, 2007.
In June 2006, the Oregon Racing Commission approved Youbet’s application to renew for one year our multi-jurisdictional simulcast and interactive wagering totalizator hub license to accept and place online and telephone horse racing pari-mutuel wagers. Also in June 2006, the Idaho State Racing Commission approved Youbet’s application to renew for one year our multi-jurisdictional simulcast and interactive wagering totalizator hub license to accept and place online and telephone horse racing and pari-mutuel wagers.
In July 2006, the Washington Horse Racing Commission approved Youbet’s application for a one-year ADW license to accept and place online and telephone horse racing and pari-mutuel wagers.
In June 2006, the Oregon Racing Commission renewed IRG’s license for a multi-jurisdictional simulcast and interactive wagering totalizator hub to accept and place telephone horse racing pari-mutuel wagers. This license is subject to renewal on an annual basis.
Other government regulation and licensing
Gaming activities are subject to extensive statutory and regulatory control by federal, state and foreign agencies and could be significantly affected by any changes in the political climate and changes to economic and regulatory policies. These changes may impact our operations in a materially adverse way. Our facilities are used by customers to place wagers and we receive commissions derived from such wagers; therefore various statutes and regulations could have a direct and material impact on our business and on the public demand for our products and services.
For a description of pertinent federal legislation, see “Industry Overview.”
In the U.S., three states prohibit all forms of gaming. From time to time, we receive correspondence from various governmental agencies inquiring into the legality of our activities. We believe that our activities conform to those federal and state laws and regulations applicable to our activities. However, we face the risk of either civil or criminal proceedings brought by governmental or private litigants who disagree with our interpretation of the applicable laws in the other 47 states, and therefore, we are at risk of losing such lawsuits or actions and may be subject to significant damages or civil or criminal penalties.
A number of states have enacted, considered or are considering interactive and Internet gaming legislation and regulations which may inhibit our ability to do business in such states, and anti-gaming conclusions and recommendations of other governmental or quasi-governmental bodies could form the basis for new laws, regulations and enforcement policies that could have a material adverse impact on our business.
Any expansion into international markets may subject us to additional regulation in those countries into which we expand. We believe that we can operate or license technology in numerous jurisdictions that allow telephone and account wagering. However, we may not be able to obtain the approvals necessary to market our services in such jurisdictions.
We have two reportable segments for accounting purposes. Our ADW segment consists of our core Youbet operations, as well as IRG and Bruen Productions. United Tote operations constitute a separate segment. For information regarding results for each segment, see Item 8 “Financial Statements and Supplementary Data—Note 15.”
Seasonality and Backlog
Our business segments are subject to seasonal fluctuations in demand associated with racing schedules. The first and fourth quarters of the calendar year traditionally comprise the weakest seasons for our pari-mutual wagering business. As a result of inclement weather during the winter months, a number of racetracks do not operate and those that do operate often experience missed racing days. This adversely affects the amounts wagered and the corresponding service revenues. However, due to the services we provide, we do not experience a material backlog in sales orders or the fulfillment of client services.
Employees
As of December 31, 2006, we had 447 full-time employees. We have never had a work stoppage. Nineteen of our United Tote employees as of December 31, 2006, were represented by a labor union. We consider our relations with our employees and the union that represents some of them to be good. We believe our future success will largely depend upon our continued ability to attract, integrate, retain and motivate highly qualified technical and managerial professionals and the continued service of our present senior management and key technical employees.
Available Information
Youbet’s Internet website address is http://www.youbet.com . We make available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC.
ITEM 1A. RISK FACTORS
The risks and uncertainties described below may not be the only risks we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations or financial results. If any of the following risks occur, our business, prospects, financial condition, operating results and cash flows could be adversely affected in amounts that could be material.
Risks Related to Our Business
If it is determined that our business practices violate state gaming laws or regulations, we could be subject to claims for damages, fines or other penalties and may be prohibited from accepting pari-mutuel wagers from these states in the future.
We currently have licenses in the states of California, Idaho, Oregon and Washington to operate an ADW multi-jurisdictional wagering hub and/or to accept wagers from residents of such states. We also accept pari-mutuel wagers from subscribers in other states where, we believe, accepting such wagers is permitted pursuant to the Interstate Horseracing Act of 1978, as amended, state laws, and certain other laws and legal principles, including those contained in the U.S. Constitution. However, state attorneys general and gaming regulators may interpret state gaming laws, the federal statutes and constitutional principles and doctrines in a narrower manner than we do. If a federal or state court were to adopt such a narrow interpretation of these laws, we may face criminal or civil damages, fines or other penalties and may be prohibited from accepting pari-mutuel wagers in one or more states in the future, which may adversely affect our business and results of operations.
In addition, if any proceedings were brought by governmental or private litigants who disagree with our interpretation of the applicable laws, the adverse publicity, cost of such litigation and diversion of management’s focus and time away from our business operations may have a materially adverse effect on our financial condition and results of operations. From time to time, we have received correspondence from various state governmental agencies inquiring into the legality of our business activities and, in certain circumstances, alleging our non-compliance with state gaming laws. To date, we have responded in a timely manner to all of these inquiries outlining our legal position, which we believe permits our business operations in such states. We cannot assure you that any of these state governmental agencies agree with our legal position or that proceedings intended to prohibit or restrict our business will not be brought against us by one or more of these state governmental agencies in the future.
Furthermore, a number of states have considered, enacted or are considering interactive and Internet gaming legislation and regulations which may inhibit our ability to do business in such states, and anti-gaming conclusions and recommendations of other governmental or quasi-governmental bodies could form the basis for new laws, regulations and enforcement policies that could have a material adverse impact on our business. The extensive regulation by both state and federal authorities of gaming activities also can be significantly affected by changes in the political climate and changes in economic and regulatory policies. Such effects could be materially adverse to Youbet and IRG.
Laws and regulations proposed by Congress and various state legislatures or federal or state authorities that are directly applicable to online and Internet gambling could have a material adverse effect on our business.
After nearly a decade of consideration, Congress recently passed Internet gambling legislation. The Unlawful Internet Gambling Enforcement Act of 2006, or the Act, was signed into law on October 13, 2006. This Act includes certain racing protective provisions by maintaining the status quo with respect to wagering activities under the Interstate Horseracing Act of 1978, as amended. Certain versions of this legislation and other bills introduced in prior years have not included exemptions applicable to our business, and we cannot be certain legislation will not be introduced in the future that could threaten to materially and adversely affect our business.
A number of states have enacted, considered or are considering interactive and Internet gaming legislation and regulations which may or may not be worded so as to permit our business to continue in such states; and anti-gaming conclusions and recommendations of other governmental or quasi-governmental bodies could form the basis for new laws, regulations, or enforcement policies that could have a material adverse effect on our business. International expansion of our business may be subject to regulation in those countries in which it is made available. We believe that we can operate or license technology in numerous jurisdictions that allow telephone and account wagering. However, we may not be able to obtain the approvals necessary to market our services in such jurisdictions.
If credit card companies, as a policy, refuse to process wagering account transactions as a result of perceived legal uncertainty surrounding online live event wagering, our business and results of operations could be adversely affected.
Credit card companies may in the future become hesitant to process deposits, fees and online transactions by our customers. This would limit the methods of payment available to our subscribers, reducing the convenience of our services, and may make competitive services more attractive. This may adversely affect our business.
If the federal government or state governments impose taxes on wagers, our business could be adversely affected.
If one or more governmental authorities successfully asserts that we should collect taxes on wagers, it could adversely affect our business. We do not currently collect taxes on wagers. We pay all applicable taxes to the State of Oregon where IRG and Youbet both have Oregon licenses and are currently regulated. However, one or more local, state or foreign jurisdictions may seek to tax online and Internet wagering when a subscriber is physically within their jurisdiction at the time the wager is placed. Such taxes, if imposed, would have a material adverse effect on our business.
If our license and content agreement with TVG is terminated or is not renewed, and if we are not able to license such content directly from the track operators, our business and results of operations may be adversely affected.
TVG has formed purported exclusive relationships with a number of major U.S. horse tracks. In May 2001, we entered into a license and content agreement with TVG. Pursuant to this agreement, we have a non-exclusive license to access the simulcast audio, video and data content, as well as the wagering pools, of certain racing content at these racetracks. If our agreement with TVG is terminated or is not renewed, or if such relationships between TVG and such racetracks are terminated or not renewed, and if, following any such termination or non-renewal, we are not able to license such content directly from the track operators, our business and results of operations may be adversely affected.
We face strong competition from the Television Games Network and others.
We believe that our principal domestic competitor in the interactive, pari-mutuel gaming market is TVG, which operates an ADW website and the Television Games Network. The Television Games Network is a 24-hour national racing channel for distribution over cable and DIRECTV ® , along with an in-home pari-mutuel wagering system that requires a dedicated television set-top box. Further expansion of the Television Games Network’s product and expansion of its purported exclusive relationships may make it difficult for us to grow our subscriber base and to obtain quality racing content. Additionally, if exclusive relationships account for a significant number of horse tracks, TVG may be able to secure relationships with additional horse tracks on more favorable terms than us.
We compete with several other companies, including America Tab, doing business as Win Ticket, Xpressbet TM , a division of Magna Entertainment Corp., and the Racing Channel, doing business as Oneclickbetting.com. Worldwide, numerous other Internet and interactive ventures exist. We expect to compete with these entities, as well as new companies which may enter the interactive, pari-mutuel gaming market. It is possible that our current and potential competitors may have greater resources than us.
If, in response to allegations brought before the WTO, the U.S. government amends existing laws to exempt foreign providers of online gambling, or restricts domestic service providers, our business could be adversely affected.
On April 7, 2005, the Appellate Body of the World Trade Organization, referred to as the WTO, circulated its report in a dispute settlement proceeding brought by the Government of Antigua and Barbuda, referred to as Antigua, challenging certain U.S. measures affecting the cross-border supply of gambling and betting services. Antigua claimed that certain federal and state laws have the effect of prohibiting the supply of gambling services from outside the U.S. in violation of certain U.S. obligations under the General Agreement on Trade in Services, referred to as GATS. In relevant part, Antigua argued that the U.S. was discriminating between domestic and foreign remote suppliers of wagering services for horse racing because the Interstate Horseracing Act purports to exempt domestic service suppliers, like Youbet, from the prohibitions of the Wire Act, the Travel Act and the Illegal Gambling Business Act, but does not exempt foreign services suppliers. The Appellate Body of the WTO found, inter alia, “that the U.S. has not shown, in light of the Interstate Horseracing Act that the prohibitions embodied in [the Wire Act, the Travel Act and the Illegal Gambling Business Act] are applied to both foreign and domestic service suppliers of remote betting services for horse racing, and therefore, has not established that these measures satisfy the requirements of [Article XIV of the GATS].” On April 20, 2005, the Appellate Body report was adopted by the Dispute Settlement Body, referred to as the DSB, of the WTO, and the U.S. was requested to bring its measures into conformity with its obligations under the GATS. The United States was given until April 5, 2006 to do so. In a submission to the WTO dated April 10, 2006, the Office of the United States Trade Representative, or the USTR, noted that a U.S. Department of Justice official had provided the following information in April 5, 2006 testimony before a Congressional committee: “The Department of Justice views the existing criminal statutes as prohibiting the interstate transmission of bets or wagers, including wagers on horse races. The Department is currently undertaking a civil investigation relating to a potential violation of law regarding this activity. We have previously stated that we do not believe that the Interstate Horse Racing Act, 15 U.S.C. •• 3001-3007, amended the existing criminal statutes.” The USTR reported, in light of these circumstances, that the United States is in compliance with its WTO obligations. On June 8, 2006, Antigua initiated proceedings in the WTO to challenge the U.S. position and to determine whether the United States is in compliance with the panel and Appellate Body findings adopted in 2005. Should the WTO find that the United States has not complied with its commitments, Antigua may seek authorization to impose trade retaliation against the United States.
Although the WTO decision and the U.S. Government’s recent submission do not affect any existing federal or state law, we cannot predict what actions, if any, the U.S. Government will take in response to any new WTO proceedings and what effect, if any, the consequences thereof will have on our business and operations.
Our inability to retain our relationships with our content providers would have a material adverse effect on our business.
We depend upon a limited number of suppliers for the majority of our content, and the cancellation of our relationship with any one of those suppliers would have a material adverse effect on our business. In addition, our right to simulcast and accept wagers on races at a number of the most recognized tracks and races, including The Preakness, one of horse racing’s triple crown races, and the Belmont Shores depends on our license agreement with Magna. Currently, we do not have a contract in place for the Kentucky Derby. The cancellation or non-renewal of our license agreements with these content providers or the cancellation or non-renewal of our agreements with a number of our other content providers would have a material adverse effect on our business.
Our inability to retain our core customer base or our failure to attract new customers would have a material adverse effect on our business.
Our data mining software generates detailed customer segmentation analyses based on variables such as wagering propensities and preferences, which allows us to personalize our product offerings through targeted special offers tailored to specific customer segments. We believe that these techniques help us to retain our best customers. In addition, our marketing relationships with the Daily Racing Form and others help us attract new customers. If we are unable to retain our core customer base through robust content offerings and other popular features, if we lose customers to our competitors, or if we fail to attract new customers, our businesses would fail to grow or would be adversely affected.
The integration of acquired businesses may result in substantial costs, delays and other problems.
Our future performance will depend on our ability to integrate the businesses that we acquire. To integrate newly acquired businesses, we must integrate certain operations and extend our financial and management controls (such as compliance with Section 404 of the Sarbanes-Oxley Act of 2002) and operating, administrative and information systems in a timely manner and on satisfactory terms and conditions. We may not be able to integrate successfully these and other acquired businesses or realize projected cost savings and synergies in connection with those acquisitions on the timetable contemplated, if at all.
Furthermore, the costs of integrating acquired businesses could impact significantly our short-term operating results. These costs could include the following:
| • | restructuring charges associated with the acquisitions; and |
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| • | non-recurring acquisition costs, including accounting and legal fees, investment banking
fees, recognition of transaction-related obligations, and various other acquisition-related
costs. |
The integration of newly acquired businesses will require the expenditure of substantial managerial, operating, financial and other resources and may also lead to a diversion of our attention from our ongoing business concerns.
Although we perform diligence on the businesses we purchase, in light of the circumstances of each transaction, an unavoidable level of risk remains regarding the actual condition of these businesses. We may not be able to ascertain the value or understand the potential liabilities of the acquired businesses and their operations until we assume operating control of the assets and operations of these businesses. Once we acquire a business, we are faced with risks, including the following:
| • | the possibility that we have acquired substantial undisclosed liabilities; |
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| • | further regulatory approvals; |
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| • | the risks of entering markets in which we have limited or no prior experience; |
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| • | the potential loss of key employees or customers; and |
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| • | the possibility that we may be unable to recruit additional managers with the necessary
skills to supplement the management of the acquired businesses. |
If we are unsuccessful in overcoming these risks, our business, financial condition or results of operations could be adversely affected.
System failures or damage from earthquakes, fires, floods, power loss, telecommunications failures, break-ins or other unforeseen events could harm our business.
Our business depends upon our communications hardware and our computer hardware, substantially all of which are located primarily at a leased facility in Woodland Hills, California. We have built certain redundancies into our systems to avoid downtime in the event of outages, system failures, or damage, however, we do not have duplicate geographic locations for our site of operations. Thus, our systems remain vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunication failures, terrorist attacks, hardware or software error, computer viruses, computer denial-of-service attacks, and similar events. Despite any precautions we may take, the occurrence of a natural disaster or other unanticipated problems could result in lengthy interruptions in our services. Any unscheduled interruption in the availability of our website and our services results in an immediate, and possibly substantial, loss of revenue. Frequent or persistent interruptions in our services could cause current or potential users to believe that our systems are unreliable, leading them to switch to our competitors or to avoid our site, and could permanently harm our reputation and brand. These interruptions also increase the burden on our engineering staff, which, in turn, could delay our introduction of new features and services on our website. We have property and business interruption insurance covering damage or interruption of our systems. However, this insurance might not be sufficient to compensate us for all losses that may occur.
We may not be able to respond to rapid technological changes in a timely manner or without service interruptions, which may cause customer dissatisfaction.
The gaming sector is characterized by the rapid development of new technologies and continuous introduction of new products. Our main technological advantage versus potential competitors is our software lead-time in the market and our experience in operating an Internet-based wagering network. However, we may not be able to maintain our competitive technological position against current and potential competitors, especially those with greater financial resources. Our success depends upon new product development and technological advancements, including the development of new wagering platforms. While we expend a significant amount of resources on research and development and product enhancement, we may not be able to continue to improve and market our existing products or technologies or develop and market new products in a timely manner. Further technological developments may cause our products or technologies to become obsolete or noncompetitive.
If we were to lose the services of Charles Champion, Gary Sproule or other key personnel, we may not be able to execute our business strategy.
Our future success depends in a large part upon the continued service of key members of our senior management team. Messrs. Champion and Sproule are critical to our overall management, as well as the development of our technology, our culture and our strategic direction. While Messrs. Champion and Sproule are parties to employment agreements, neither of these agreements prohibits the executive from terminating such an agreement. Our future success depends on our ability to identify, attract, hire, train, retain and motivate highly skilled technical, managerial, marketing, finance/accounting and customer service personnel. Competition for such personnel is intense, and we may not be able to retain and attract such employees.
Our operating results fluctuate seasonally and may be adversely impacted by a reduction in live racing dates as a result of regulatory factors.
We experience significant fluctuations in quarterly operating results as a result of the seasonality associated with the racing schedules. Generally, revenue is greater in the second and third quarters of the calendar year. Youbet and IRG carry a limited number of live racing dates and the number of live racing dates varies somewhat from year to year. The allocation of live racing dates in most of the jurisdictions is subject to regulatory approval from year to year and, in any given year, there may not be the same or more racing dates than in prior years. A significant decrease in the number of live racing dates would reduce our revenue and cause our businesses to suffer.
If the horse racing tracks that we carry experience unfavorable weather, it may cause races to be cancelled which would reduce our revenue and cause our business to suffer.
Because horse racing is conducted outdoors, unfavorable weather conditions, including extremely high or low temperatures, excessive precipitation, storms or hurricanes, may cause races to be cancelled. For example, in the fourth quarter of 2005, due largely to inclement weather, we carried 300 fewer races at predominantly premier tracks, than in the fourth quarter of 2004. Because a substantial portion of our operating expenses is fixed, a reduction in the number of races held or in the number of horses racing due to unfavorable weather would reduce our revenue and cause our businesses to suffer.
A horse racing industry controversy could cause a decline in bettor confidence and result in changes to legislation, regulation or industry practices, which could materially reduce the amount wagered on horse racing and increase our costs, and therefore, adversely affect our revenue and operating results.
A horse racing industry controversy could cause a decline in bettor confidence and result in changes to legislation, regulation or industry practices. For example, on October 26, 2002, in connection with the Breeders’ Cup World Thoroughbred Championships held at Arlington Park in Chicago, Illinois, only one person placed winning bets on the Pick 6, a bet to pick the winning horse in six consecutive races. The bettor purchased all six winning tickets, valued at more than $2.5 million, through an off-track betting telephone system. Payment of the winnings was withheld when an examination of the winning bets revealed an unusual betting pattern. Scientific Games Corporation, the parent company of Autotote Systems, Inc., later announced that it had fired an employee who had allegedly accessed the totalizator system operated by Autotote Systems, altered the winning Pick 6 tickets, and erased the record of his access. The Federal Bureau of Investigation conducted an investigation, and three individuals pled guilty in federal court to conspiring to commit fraud and money laundering. Industry controversy, like the Pick 6 matter, could result in a perceived lack of integrity or security, a decline in bettor confidence, and likely lead to a decline in the amount wagered on horse racing. Any such controversy could lead to changes in legislation, regulation or industry practices, which could result in a material reduction in the amount wagered on horse racing and in the revenue and earnings of companies in the horse racing industry, including us.
The inability of our systems and controls to handle online security risks would have a material adverse effect on our business.
We use packet filters, firewalls and proxy servers which are all designed to control and filter the data allowed to enter our data centers. However, advances in computer capabilities, new discoveries in the field of cryptography or other events or developments may make it easier for someone to compromise or breach the technology we use to protect our subscribers’ transaction data. If such a breach of security were to occur, it could cause interruptions in service and loss of data or cessation in service to our subscribers. This may also allow someone to introduce a “virus” or other harmful component to Youbet causing an interruption or malfunction.
To the extent our activities involve the storage and transmission of information such as credit card numbers, security breaches could damage our reputation and expose us to a risk of loss or litigation and possible liability. Our insurance policies might not be sufficient to reimburse us for losses caused by such security breaches.
Our inability to collect revenue due to the NYRA bankruptcy could reduce our revenue and cause our businesses to suffer.
The New York Racing Association, or NYRA , is the nonprofit operator of Aqueduct Racetrack, Belmont Park, and Saratoga Race Course. On November 2, 2006, NYRA filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York. At December 31, 2006, we had outstanding accounts receivable from NYRA of approximately $0.8 million, and we have not recorded a reserve against these receivables. Any inability to collect the outstanding accounts receivable pursuant to agreements with NYRA because of NYRA’s bankruptcy filing would reduce our revenue and cause our businesses to suffer.
Additional Risks Related to United Tote
United Tote’s totalizator business depends on its relationships with its track and other partners for a substantial portion of its revenue. The loss of all or a portion of these relationships could result in the failure to realize the expected level of revenue from our acquisition of United Tote.
United Tote has contracts to provide totalizator services to more than 100 tracks and other sporting venues that accept wagers, such as Jai Lai. As a result, the success of our acquisition of United Tote depends, in part, on our ability to maintain successful relationships with United Tote’s contract partners. Should these contract partners discontinue purchasing totalizator services from United Tote, we will fail to realize our expected increase in revenue from our acquisition of United Tote.
United Tote’s totalizator business depends on the total amount of wagers placed with its track partners.
Many of United Tote’s contracts provide that it will receive a percentage of the pari-mutuel wagering pools for which it provides totalizator services. As the amount of pari-mutuel pools increases, United Tote’s revenue increases. Accordingly, a decrease in wagers placed at one or more of United Tote’s contract partners could cause a decline in United Tote’s wagers (or revenue) and, in turn, our consolidated revenue as the owner of United Tote. Further, any material reduction by any one of United Tote’s contract partners in its level of commitment of resources, funding, personnel, and interest in continued development of horse racing or other wagering-based businesses could cause a decline in wagering and United Tote’s and our consolidated revenue.
United Tote’s totalizator business depends upon leading with and responding to technological changes.
United Tote’s success depends upon new product development and technological advancements, including the development of more advanced wagering terminals. While United Tote devotes resources to research and development and product enhancement, it may not be able to continue to improve and market existing products or technologies or successfully develop and market new products in a timely manner. Further technological developments by competitors may cause United Tote products or technologies to become obsolete or noncompetitive.
Risks Related to Ownership of Our Common Stock
The share price of our common stock may be volatile and could decline substantially.
The trading price of our common stock has been volatile and is likely to continue to be volatile. Our stock price could be subject to wide fluctuations in response to a variety of issues, including broad market factors that may have a material adverse impact on our stock price, regardless of actual performance. These factors include the following:
| • | periodic variations in the actual or anticipated financial results of our business or
that of our competitors; |
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| • | downward revisions in securities analysts’ estimates of our future operating results or
of the future operating results of our competitors; |
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| • | material announcements by us or our competitors; |
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| • | public sales of a substantial number of shares of our common stock; and |
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| • | adverse changes in general market conditions or economic trends or in conditions or
trends in the markets in which we operate. |
If our quarterly results are below the expectations of securities market analysts and investors, the price of our common stock may decline.
Many factors, including those described in this report, can affect our business, financial condition and results of operations, which makes the prediction of our financial results difficult. These factors include:
| • | changes in market conditions that can affect the demand for horse race wagering; |
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| • | general economic conditions that affect the availability of disposable income among consumers; and |
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| • | the actions of our competitors. |
If our quarterly operating results fall below the expectations of securities market analysts and investors due to these or other risks, securities analysts may downgrade our common stock and some of our stockholders may sell their shares, which could adversely affect the trading prices of our common stock.
We have the ability to issue additional equity securities, which would lead to further dilution of our issued and outstanding common stock.
The issuance of additional equity securities or securities convertible into equity securities would result in dilution of then-existing stockholders’ equity interests in us. Our Board of Directors has the authority to issue, without vote or action of stockholders, up to 1,000,000 shares of preferred stock in one or more series, and has the ability to fix the rights, preferences, privileges and restrictions of any such series. Any such series of preferred stock could contain dividend rights, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences or other rights superior to the rights of holders of our common stock. If we issue convertible preferred stock, a subsequent conversion may dilute the current common stockholders’ interest. Our Board of Directors has no present intention of issuing any such preferred stock, but reserves the right to do so in the future. In addition, we may issue up to 57,881,554 shares of common stock that are authorized but not issued, and as of December 31, 2006, 3,640,120 of our authorized but unissued shares of common stock in the aggregate were issuable upon the exercise of vested options.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
