KNBA Kinbasha Gaming International Inc (CE)

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We own and operate 21 pachinko parlors in Japan.  Our revenues consist primarily of customer wagers at our parlors and to a lesser extent food and beverages sold at these parlors.  Our costs include payoffs to customers, the costs of operating the pachinko parlors, and general and administrative costs.

Historically, in addition to our pachinko operations, we operated restaurants and two hotels.  These businesses were generally unsuccessful and materially adversely affected our results of operations and financial condition.  We closed or sold all of these more than two years ago except for three restaurants which we sold the business rights on July 1, 2012.  In that sale, we retained the physical assets of the restaurants consisting of land, buildings and fixed assets, which we leased to the new operator for $26,000 per month for two years.

Our functional currency is the yen, and accordingly our earnings and assets are denominated in yen.  As a result, appreciation or depreciation in the value of the yen relative to the dollar would affect our financial results reported in dollars without giving effect to any underlying change in our business or results of operations.  In the first nine months of fiscal year 2013, the yen was generally weaker when compared to the dollar during the first nine months of fiscal year 2012, and accordingly our results of operations reported in dollars appear weaker than they are when expressed in yen.  

Our revenues increased to $72.9 million in the nine months ended December 31, 2012 from $68.6 million in the nine months ended December 31, 2011.  The principal reason for this increase was that the first six months of fiscal 2011 were adversely impacted by the major earthquake in Japan in March 2011. Our revenues decreased to $23.7 million in the three months ended December 31, 2012 from $26.9 million in the three months ended December 31, 2011 principally because of the sale of the restaurants in July 2012, as our pachinko revenues were about the same in each of these periods.

We had net income of $7.3 million and $5.0 million in the three months and nine months ended December 31, 2012, respectively, as compared to net income of $1.4 million and net loss of $8.6 million in the three months and nine months ended December 31, 2011, respectively.  The improvement in our operating results was due principally to increased gaming revenues as we recovered from the effects of the March 2011 earthquake.  In addition, in the third quarter of fiscal 2012 we had gain of $3.0 million as a result of a change in accounting estimate for our liability for employment termination benefits due to a change in our policy relating to those benefits.

We generally finance the costs of opening our pachinko parlors and pachinko machines and other fixed assets used in the parlors.  This debt is usually secured by the real estate or equipment purchased.   As of December 31, 2012, we had total debt of $149.9 million, of which $112.4 million was in default.  We incurred most of this debt in default in the early 2000s to finance expansion efforts.  Since 2006, we have worked with our lenders and in many cases have obtained forbearances and loan modifications that have allowed us to effectively extend the maturity of our debt through interest only and/or reduced principal payments, generally negotiated on a six month or annual basis.  Lenders with whom we have not negotiated forbearances or loan modifications have accepted lower payments without bringing legal action or foreclosing on their security.  As of the date of this report, we were not subject to any litigation or foreclosure proceedings with respect to our debt.  

Our future success will depend in part upon our ability to restructure a substantial part of our defaulted debt to obtain forgiveness of some amount of principal and interest (including default interest) and/or the material extension of the maturity dates of the debt, or to refinance that debt on more favorable terms.  There is no assurance that our lenders will agree to forgive any portion of our debt or continue to accept reduced payments or that we will be able to refinance the debt.

In addition, our plan is to open new pachinko parlors in the Tokyo metropolitan area, as our existing Tokyo parlors have been more successful than our Ibaraki and Chiba parlors.  However, we will need financing to open any new pachinko parlors, and it will be very difficult for us to obtain additional financing because of our current financial condition and recent operating results.  

Results of Operations  --   Comparison of Quarters ended December 31, 2012 and 2011

Our net gaming revenues decreased in the quarter ended December 31, 2012 from the quarter ended December 31, 2011 as a result of a 4.7% decrease in the yen/dollar exchange rate. When expressed in yen, net gaming revenues increased 4.2% in the quarter ended December 31, 2012 from the quarter ended December 31, 2011 and total wagers increased 1.7% in the quarter ended December 31, 2012 from the quarter ended December 31, 2011. Total wagers in the quarter ended December 31, 2012, increased as a result of the reopening in April 2012 of a pachinko parlor that had been closed because of earthquake in March 2011. Our active pachinko machines increased from 7,088 at December 31, 2011 to 7,463 at December 31, 2012.

Our pay-out ratio decreased from 82.3% in the quarter ended December 31, 2011 to 81.7% in the quarter ended December 31, 2012, which positively impacted our net gaming revenues.  Our payout ratio decreased due to a change in the mix of pachinko machines played by our customers and the positive effects of our marketing programs which were designed to promote general prize payouts, which have a lower cost than special prizes.

Revenues from our food and beverage operations decreased from $3.4 million in the quarter ended December 31, 2011 to $431,000 in the quarter ended December 31, 2012.  The decrease was due primarily to the sale of business rights for our three remaining restaurants on July 1, 2012, and therefore we did not generate any revenues from these restaurants in the quarter ended December 31, 2012 except for $78,000 of rental income.  

 Our cost of revenues decreased by $4.1 million from the quarter ended December 31, 2011 to the quarter ended December 31, 2012.  This decrease resulted from decreases of (i) $824,000 in food and beverage costs due to the sale of the business rights for restaurants; (ii) $589,000 in salaries and wages; and (iii) $1.9 million in depreciation expense primarily due to reduced capital expenditures for pachinko assets.

The decrease in the cost of revenues as a percentage of revenues from the quarter ended December 31, 2011 to the quarter ended December 31, 2012 was due to an 11.9% decrease in revenues compared to a 23.0% decrease in the cost of revenues.

Marketing and advertising expenses decreased from $1.0 million in the quarter ended December 31, 2011 to $748,000 in the quarter ended December 31, 2012.  This decrease was due to a reduction in advertising expenditures following the adoption in July 2012 of regulations for Japanese pachinko parlors that limit conducting promotions offering higher payoffs by day or machine.  We believe that these new regulations may adversely affect the amount of wagers at smaller pachinko parlors throughout the pachinko industry.

In the third quarter of 2012, we recognized a $3.0 million gain from change in termination benefits. This gain resulted from a change in October 2012 in our policy for termination benefits payable to our employees upon termination of employment which reduced other liabilities by that amount. We accounted for this change as a change in accounting estimate.  See Note 7 of Notes to Condensed Consolidated Financial Statements.

General and administrative expenses decreased from $3.5 million in the quarter ended December 31, 2011 to $2.8 million in the quarter ended December 31, 2012.  This decrease was due primarily to (i) a $260,000 reduction in compensation expense for administrative employees due to a decrease in the number of administrative employees; and (ii) $187,500 of compensation expense in the 2011 quarter relating to shares issued in March 2012 to our chief executive officer for services rendered in fiscal years 2010 through 2012.

The decrease in operating expenses as a percentage of net revenues from the quarter ended December 31, 2011 to the quarter ended December 31, 2012 was due to a 11.9% decrease in net revenues compared to a 87.4% decrease in operating expenses, which also reflects a non-recurring gain from change in employment termination benefits of 65.4% during the quarter ended December 31, 2012.

Interest Expense

Interest expense decreased from $3.2 million in the quarter ended December 31, 2011 to $2.1 million in the quarter ended December 31, 2012. Interest expense decreased because of  lower default interest in the 2012 period as a result of revised payment terms with a number of creditors.

Results of Operations  --   Comparison of Nine Months ended December 31, 2012 and 2011

Our net gaming revenues increased by $8.2 million or 13.3% in the nine months ended December 31, 2012 from the nine months ended December 31, 2011 principally because of increased wagers and lower payout levels.  These increases occurred notwithstanding the slight strengthening of the dollar versus the yen in fiscal 2013, which adversely effects our results of operations when expressed in dollars.  

Total wagers in the first six months of fiscal 2012 were adversely affected by the March 2011 earthquake. We reopened a parlor in April 2012 that was badly damaged by the earthquake and had been closed since March 2011.

Our pay-out ratio decreased from 84.0% in the nine months ended December 31, 2011 to 82.5% in the nine months ended December 31, 2012, which positively impacted our net gaming revenues.  Our payout ratio decreased due to change in the mix of pachinko machines played by our customers and marketing programs designed to promote general prize payouts, which have a lower cost than special prizes, as well as the fact that we increased the pay-out ratios intentionally through the first six months of fiscal year 2012 to generate greater customer traffic following the March 2011 earthquake.

Revenues from our food and beverage operations decreased from $6.6 million in the nine months ended December 31, 2011 to $2.7 million in the nine months ended December 31, 2012.  This decrease was primarily due to the sale of the business rights for our remaining three restaurants on July 1, 2012, and we did not generate any revenues from these restaurants except rental income from those three restaurants after that date.

Our cost of revenues decreased by $2.8 million from the nine months ended December 31, 2011 to the nine months ended December 31, 2012.  This decrease was due primarily to decreases of $1.3 million in depreciation expense primarily due to reduced capital expenditures for pachinko assets and $0.9 million in costs related to food and beverage operations due to the sale of the business rights for the restaurants.

The decrease in the cost of revenues as a percentage of net revenues from the nine months ended December 31, 2011 to the nine months ended December 31, 2012 was due to a 6.4% increase in net revenues compared to a 5.1% decrease in the cost of revenues.

Marketing and advertising expenses were $2.8 million and $2.6 million in the nine months ended December 31, 2011 and 2012, respectively.  This decrease was due to a reduction in advertising expenditures following the adoption in July 2012 of regulations for Japanese pachinko parlors that limit conducting promotions offering higher payoffs by day or machine.

In the third quarter of 2012, we recognized a $3.0 million gain from change in termination benefits. This gain resulted from a change in October 2012 in our policy for termination benefits payable to our employees upon termination of employment, which reduced other liabilities by that amount. We accounted for this change as a change in accounting estimate.  See Note 7 of Notes to Condensed Consolidated Financial Statements.

General and administrative expenses remained relatively stable during the nine months ended December 31, 2011 compared to the nine months ended December 31, 2012. General and administrative expenses in the nine months ended December 31, 2011 included $562,000 of compensation expense relating to shares issued in March 2012 to our chief executive officer for services rendered in fiscal years 2010 through 2012.

The decrease in operating expenses as a percentage of net revenues from the nine months ended December 31, 2011 to the nine months ended December 31, 2012 was due to a 6.4% increase in net revenues compared to a 27.0% decrease in operating expenses, which also reflects a non-recurring gain from change in employment termination benefits of 24.2% during the nine months ended December 31, 2012.

Interest Expense

Interest expense was $9.2 million and $6.3 million in the nine months ended December 31, 2011 and 2012, respectively.  Interest expense was lower in the 2012 period because of lower default interest in the 2012 period as a result of revised payment terms with a number of creditors.

Financial Condition and Liquidity

Financial Condition

Property and equipment decreased from $120.4 million at March 31, 2012 to $116.1 million at December 31, 2012, principally because of 4.4% of increase in the yen to dollar exchange rate. We had $5.8 million of capital expenditures relating to the pachinko parlor we reopened in May 2012, which were offset in part by reduced capital expenditures for pachinko machines at our other pachinko parlors.

Other assets decreased from $14.2 million at March 31, 2012, to $13.2 million at December 31, 2012 due primarily to the change in the yen to dollar exchange rate.  

Our accounts payable and accrued expenses increased by $647,000 from March 31, 2012 to December 31, 2012, due principally to accounts payable relating to improvements to the pachinko parlor we reopened in May 2012.

Our debt, consisting of notes payable, capital lease obligations, bonds and related party debt, was $159.8 million at March 31, 2012 and $149.9 million at December 31, 2012.  At December 31, 2012, the debt included $123.8 million of principal and $26.1 million of accrued interest (including default or penalty interest).  The bank debt and capital lease obligations were obtained principally to finance the purchase of equipment, the construction or renovation of our pachinko parlors, or in certain cases the land on which our pachinko parlors are located.  These loans and leases are secured by the equipment, leasehold improvements or land purchased, and substantially all of our assets are collateral for one or more of our loans.  Our bank debt, in the aggregate amount of $119.7 million at December 31, 2012, is secured and bears interest at fixed rates ranging from 0.09% per annum to 4.4% per annum (other than default rates), with a weighted average fixed rate of 3.50% per annum at December 31, 2012.  Our finance company debt, in the aggregate amount of $7.4 million at December 31, 2012, is generally unsecured and bears interest at fixed rates ranging from 6.0% per annum to 44.75% per annum, with a weighted average fixed rate of approximately 8.5% per annum at December 31, 2012.

Debt in Default

At December 31, 2012, we were in default on debt in the aggregate amount of $106.5 million, as compared to $126.9 million at March 31, 2012.  At December 31, 2012, debt in default included principal of $86.2 million and accrued interest (including default or penalty interest) of $20.3 million.  The decrease in the amount of debt in default was due to principal repayments and the restructuring of one loan in the principal amount of $6.5 million..

This debt has been in default for periods of up to six years.  Most of the debt provides for penalties or default interest upon default, generally at 14% per annum. To date, most of the lenders have not enforced this provision but there is no assurance they will not do so in the future.

  For the past several years, we have worked with our lenders and in many cases have obtained forbearances and loan modifications that have allowed us to effectively extend the maturity of our debt through interest only and/or reduced principal payments, generally negotiated on a six month or annual basis.  Lenders with whom we have not negotiated forbearances or loan modifications have accepted lower payments without bringing legal action or foreclosing on their security.  As of the date of this registration statement, we were not subject to any litigation or foreclosure proceedings with respect to our debt.  

The following table provides certain information regarding our debt in default with respect to each lender to whom our defaulted debt exceeded 5% of our total assets at December 31, 2012.  The outstanding balances are as of December 31, 2012.

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(1)

Year of first default

(2)

A is accrued interest, D is default interest accrued.

(3)

All of the Company’s real properties are collateralized by one or more mortgages, in some cases up to four mortgages.  

(4)

Since the initial defaults in 2006, we have been making monthly payments in amounts based on discussions with our lenders, with an agreed upon interest rate of 3.5% per annum.  The amount of the payments varies from time to time (generally on an annual basis), based primarily on the amount of principal payments we advise the lenders we can make.  The principal payment ratio in fiscal year 2012 is 1%, as compared to 0.5% in fiscal year 2012 and 0% in fiscal year 2011.  While most of our lenders have accepted payments at these rates in the past, they have not been obligated to do so there is no assurance they will continue to accept such payments in the future.  

Our future success will depend in part upon our ability to renegotiate a substantial part of our defaulted debt or refinance the debt on more favorable terms.  We will seek to obtain forgiveness of some amount of principal and interest (including default interest) and/or the material extension of the maturity dates of the debt.  For example, in February 2012, we restructured a loan in the amount of $6.5 million (including principal, accrued interest and default interest) to provide that if we make 12 monthly payments of $12,000, and a final payment of $840,000 in February 2013, the balance of the debt ($5.5 million) will be forgiven.  However, there is no assurance that any of our other lenders will agree to forgive any portion of our debt or continue to accept reduced payments, or that we will be able to refinance any portion of the debt.  

In 2009, the Japanese government imposed a moratorium on lenders regarding loans to homeowners and small to medium sized businesses.  Lenders were encouraged, but not obligated, to agree to loan modifications to extend maturity dates, reduce payments and forgive portions of the loan.  This moratorium is presently scheduled to expire on March 31, 2013.  It is possible that some of our lenders may have been dissuaded from more aggressive collection efforts by the moratorium, and may bring litigation or foreclosure actions if the moratorium ends.  

Our future success depends in large part on our ability to restructure and refinance our debt in order to reduce interest costs and match current debt payments with available cash flow.  If we are unable to restructure or refinance our debt, we face potential litigation and foreclosure on our existing assets.  Further, collection or foreclosure actions by some lenders may induce other lenders to take similar actions.  Because we do not have the financial resources to pay our defaulted debt, our creditors could force Kinbasha Japan into a liquidation bankruptcy, in which event we would lose our pachinko licenses and Kinbasha Japan would cease operations.

Cash Flows

During the nine months ended December 31, 2012 and 2011, we generated $28.5 million and $26.9 million, respectively, of cash flows from operating activities.  The increase in cash flows from operating activities was the result of higher net income as the 2011 period was adversely impacted by the major earthquake in Japan in March 2011.

During the nine months ended December 31, 2012 and 2011, we used cash of $22.5 million and $19.3 million, respectively, for investing activities. This change was due to $5.8 million of capital expenditures relating to the pachinko parlor we reopened in May 2012 offset in part by reduced capital expenditures at our other parlors.

During the nine months ended December 31, 2012 and 2011, we used cash of $6.3 million and $6.6 million, respectively, for financing activities, primarily to pay debt.  We are generally required to apply any net positive cash flow from our operating and investing activities to repay debt.

Liquidity

Although we had net income of $5.0 million in the nine months ended December 31, 2013, we incurred net losses during fiscal years 2012 and 2011, and as of December 31, 2012 and March 31, 2012 we had working capital and shareholders’ deficits.  Starting in 2006, we had begun experiencing financial problems, which has caused us to become delinquent in repayment of a large portion of our debt.  

We do not have the financial resources or liquidity to repay our debt that is in default.  Most of this debt has been in default since 2006.  During this period, we have worked with our lenders and in many cases have obtained forbearances and loan modifications that have allowed us to effectively extend the maturity of our debt through interest only and/or reduced principal payments, generally negotiated on a six month or annual basis.  Lenders with whom we have not negotiated forbearances or loan modifications have accepted lower payments without bringing legal action or foreclosing on their security.  As of December 31, 2012, none of our lenders had brought litigation or foreclosure proceedings with respect to any of our debt.

Assuming our lenders continue to accepts payments at levels comparable to our payment levels during the past several years and do not initiate other collection or foreclosure actions, and assuming there is no material adverse change in the pachinko industry generally, we believe our business will generate sufficient cash from operations to pay our expenses when due for the next twelve months.

However, at current levels, we are not generating sufficient cash flows to make any substantial reduction in our outstanding debt.  We will attempt to renegotiate a substantial part of our debt to obtain the forgiveness of some amount of principal and accrued interest (including default interest) and/or the material extension of the maturity dates of the debt.  We can provide no assurance that our lenders will agree to any of these changes or will not seek to collect their loans through litigation or foreclose actions.   

We also want to open new pachinko parlors in the Tokyo metropolitan area, where our more successful pachinko parlors are located, to generate greater positive cash flow.  To do this, we will need additional financing and we have had difficulty obtaining financing as a result of our current financial condition and recent operating results.  There are no assurances that we will be able to obtain this financing or be successful in our plans.

Our condensed consolidated financial statements do not reflect any adjustments to the carrying value of assets or liabilities as a result of the uncertainty about our ability to pay obligations as they become due.  Our independent registered public accounting firm has included an explanatory paragraph in their report on our most recent annual audited financial statements expressing substantial doubt about our ability to continue as a going concern because of these matters, as required by auditing standards of the Public Company Accounting Oversight Board (United States).

Foreign Currency Adjustments

Our functional currency is the yen.  Our condensed consolidated financial statements are translated into United States dollars at period-end exchange rates for assets and liabilities, and weighted-average exchange rates for revenues and expenses.  The resulting translation adjustments are included in determining comprehensive income.  The accumulated foreign currency translation adjustment account is also recorded as a separate component of shareholders’ deficit.  Transaction gains and losses, if any, in foreign currencies are reflected in operations.  

The exchange rate was 85.88 yen to 1 dollar at December 31, 2012, and 82.27 yen to 1 dollar at March 31, 2012.  The average exchange rate was 81.13 yen to 1 dollar and 79.96 yen to 1 dollar in the three and nine months ended December 31, 2012, respectively, compared to 77.31 yen to 1 dollar and 78.88 yen to 1 dollar in the three and nine months ended December 31, 2011, respectively.  Even when we experience an increase or decrease in our results of operations, the results in dollars may not reflect the correlational results due to fluctuation of the currency rate in the market.  For example, when the yen gets weaker versus the dollar from one period to the next period, our financial results will appear stronger when expressed in dollars comparing the first period to the next period.

Item 3.