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The following is an excerpt from a 10-K405 SEC Filing, filed by INTERLOTT TECHNOLOGIES INC on 3/31/1998.
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INTERLOTT TECHNOLOGIES INC - 10-K405 - 19980331 - PART_I

PART I

ITEM 1. BUSINESS

General

In addition to historical information, this report and the Company's 1997 Annual Report include forward looking statements and information based on management's beliefs, plans, expectations and assumptions and on currently available information. The words "expect," "anticipate," "intend," "plan," "believe," "seek," "estimate" and similar expressions used in this report and the 1997 Annual Report are intended to identify forward looking statements, although this report and the 1997 Annual Report also contains other forward looking statements. The forward looking statements in this report are not guarantees of future performance and involve certain risks, uncertainties and assumptions, many of which are beyond the Company's control. Such factors include particularly, but are not limited to, the level of market acceptance of ITVMs and PCDMs generally as well as the demand for the Company's ITVMs and PCDMs. As a result of the various risks, uncertainties and assumptions underlying the forward looking statements in this report and the 1997 Annual Report, the Company's future actions, financial condition, results of operations and stockholder values could differ materially from any forward looking statement made by the Company. All written or oral forward looking statements attributable to the Company are expressly qualified in their entirety by the cautionary statements that explain or qualify the foward looking statements.

Interlott Technologies, Inc. (the "Company") is engaged primarily in the design, manufacture, sale, lease and service of instant winner lottery ticket vending machines ("ITVMs"). ITVMs are used by public lotteries operated by states and foreign public entities to dispense instant winner lottery tickets primarily in retail locations such as supermarkets and convenience stores. An instant lottery commonly is played by players scratching off a latex coating from a pre-printed ticket or tearing pull-tabs from a pre-printed ticket to determine the outcome of the game. The Company's ITVMs dispense instant lottery tickets without the assistance of an employee of the lottery instant ticket retailer or agent, thereby permitting the retailer or agent to sell tickets without disrupting the normal duties of its employees.

The Company's ITVMs dispense scratch-off instant lottery tickets using a dispensing process that incorporates the Company's patented "burster technology." The Company believes that this burster technology is superior to any other ITVM scratch-off dispensing technology on the market and considers it to be a key to its marketing efforts and the ITVM procurement decisions of the various lotteries. The Company is unaware of any competitor that incorporates a substantially equivalent or superior scratch-off dispensing mechanism in its ITVMs. To dispense pull-tab instant lottery tickets, the Company has developed an ITVM that incorporates a patented dispensing technology which is different than the burster technology but that is also believed by the Company to be superior to any other currently available pull-tab dispensing technology. ITVMs that dispense pull-tab tickets are sometimes referred to herein as "pull tab vending machines" or "PTVMs." The term "ITVM" includes both scratch-off vending machines and PTVMs unless the context indicates otherwise.

As of December 31, 1997, the Company had sold or leased 12,414 ITVMs under agreements with 22 different state lotteries and six foreign jurisdictions, or their licensees or contractors. The Company was awarded four of the five domestic ITVM contracts that were awarded in 1996 and five of the six contracts that were awarded in 1997. Additionally, lotteries in eight states and eight foreign jurisdictions currently are testing the Company's ITVMs or have requested the Company to provide ITVMs for testing.

The Company continually seeks to enhance its existing product lines and develop new products. The Company has developed a prepaid phone card dispensing machine ("PCDM") that enables providers of long distance telephone service to dispense prepaid telephone calling cards in retail locations without the assistance of an employee of the retailer. The dispensing process used in the Company's PCDM incorporates the same patented technology used in the Company's PTVM, and the Company believes that this dispensing technology is superior to any other PCDM dispensing technology on the market. Sales of the Company's PCDMs began in the latter part of 1995, and as of December 31, 1997, the Company had sold or leased a total of 695 PCDMs. PCDM revenues in 1996 and 1997 represented 2% and 2.5% of total revenues, respectively.

The Company was incorporated on February 20, 1990 under the laws of Ohio and was reincorporated under the laws of Delaware on March 18, 1994. In April 1994, the Company completed an initial public offering of Common Stock, and the Company's Common Stock now trades on the American Stock Exchange under the symbol "ILI."

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Industry Overview

ITVMS

The popularity and success of lotteries has increased worldwide in recent years, and the popularity of instant lotteries has increased at a rate that is greater than that of lotteries generally. Currently 37 states and the District of Columbia operate lotteries as compared to 29 states as of June 30, 1989, and 37 states and the District of Columbia currently operate instant lotteries as compared to 28 states as of June 30, 1989. The Company believes that factors contributing to the rapid growth in the popularity and success of instant ticket games, which now comprise 45% of total lottery sales in the United States as compared to 24% in 1989, include more sophisticated marketing techniques, the introduction of new state instant ticket lotteries, a broader appeal among lottery consumers and increased technological advances in the distribution of instant tickets.

ITVMs were first deployed to serve the instant lottery market in 1991, and the market for ITVMs has grown rapidly in subsequent years. The number of installed ITVMs has increased from approximately 900 in 2 states in 1991 to approximately 24,100 in 31 states, the District of Columbia and eight foreign jurisdictions as of December 31, 1997. Three states and four foreign jurisdictions currently are testing or preparing to test ITVMs in the field, and the Company believes that several other states and foreign jurisdictions are considering the use of ITVMs. Additionally, because states that utilize ITVMs typically introduce the ITVMs into the instant ticket distribution system in stages (preferring to test retail reception to a limited initial deployment of ITVMs before fully committing funds to the deployment of a significantly larger number of ITVMs), the Company believes that states currently utilizing ITVMs represent a growing market for the Company's ITVMs.

Although the Company believes that sales of instant lottery tickets and the use of ITVMs will continue to increase, any decline in the popularity of instant lottery games or in the market acceptance of ITVMs, as well as any other event that results in a decrease in leasing or purchasing ITVMs by lotteries, would have a material adverse effect on the Company. The Company's ability to generate additional revenues and earnings will depend upon the continuation of existing leases of ITVMs, orders for additional ITVMs by the lotteries that currently utilize ITVMs, the implementation of programs that use ITVMs to distribute tickets in the six additional states as well as foreign jurisdictions that have instant ticket lotteries, and the approval of lotteries by the remaining states and foreign jurisdictions. Future orders of ITVMs by lotteries will depend in large part on continued market acceptance of ITVMs, of which there can be no assurance. Accordingly, there can be no assurance that any significant number of jurisdictions will implement or expand lottery programs that utilize ITVMs.

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PCDMS

Like instant lottery tickets, the use of prepaid telephone calling cards also has grown significantly in the past few years. Prepaid telephone calling cards enable callers to make long distance calls at rates that typically are lower than the rates ordinarily charged for credit card or collect long distance telephone calls. This factor, together with the usage control that results from the pre-established value of the card, is perceived as a distinct value of the card and is believed to be responsible for the popularity of prepaid telephone calling cards.

The use of PCDMs as a method of distribution of prepaid telephone calling cards has paralleled the market acceptance of the card. PCDMs are now being used successfully to sell prepaid telephone calling cards in truck stops, military bases, convenience stores, airports, and numerous other types of retail locations. The Company believes that the sale of prepaid long distance calling cards and the use of PCDMs are in the very early stages of market development in the United States and anticipates the continued development of the market. However, any decline in the popularity of prepaid telephone calling cards or in the market acceptance of PCDMs would limit the Company's ability to generate revenues and earnings from its PCDMs. There can be no assurance that the Company will be able to develop successfully the market for its PCDMs.

Business Strategy

The Company's business strategy involves the following elements:

- Expansion of the Company's ITVM into new domestic and international markets. Lotteries are becoming increasingly aware of the success of ITVMs in increasing instant ticket revenues, and many domestic and international jurisdictions are currently testing and evaluating ITVMs. In the United States, the Company currently is testing or preparing for testing of ITVMs for lotteries in Idaho, Indiana and West Virginia. Internationally, the Company currently is testing or preparing for testing of ITVMs for lotteries in Costa Rica, France, Quebec and Switzerland. The Company plans to expand further into new and existing lottery jurisdictions by expanding its marketing efforts and lowering the cost associated with the procurement of its ITVMs. The Company also intends to continue to aggressively market its ITVM products and services to its existing customers to encourage expanded use of ITVMs in existing distribution systems.

- PCDM market penetration. The Company has made only an initial and limited penetration of the PCDM market to date, but the Company is actively seeking to become a significant presence in the PCDM market in the United States. The Company believes that its ITVM has a reputation for quality, performance and reliability, and the Company intends to capitalize on this reputation in marketing its PCDM to providers of long distance telephone services. The Company also intends to demonstrate to such providers the advantages which its PCDM affords to the retailers that sell prepaid telephone calling cards, which in turn should lead to increased sales of prepaid calling cards by such providers. To this end, the Company is working closely with several providers of long distance telephone service to expand the use of PCDMs in the distribution of prepaid telephone calling cards. Four such providers are currently testing or preparing to test the Company's PCDM. The Company also intends to aggressively market its PCDM products to its existing customers and to expand its marketing efforts to both the providers and resellers of long distance services, as well as to market its PDCMs to retailers of prepaid telephone cards.

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- Continued product innovation and technological advances. Management believes that the Company's products are more technologically advanced than the products of its competitors and that the technological superiority of the Company's ITVM is a principal reason for its success to date. To further expand the Company's market opportunities, the Company continually seeks to enhance its existing products and develop complementary products that offer the superior operating performance of its ITVMs and PCDMs. For example, the Company has developed a compact, no-frills PCDM to address the needs of those customers who do not desire a full-service machine. The Company also has enhanced its software to interact with currency acceptors of foreign currency and display messages in foreign languages. Finally, the Company has improved its on-line communications system.

- Manufacturing efficiencies. The Company continually seeks to enhance its manufacturing operations to improve its gross margins and overall profitability. The Company believes that through design refinements and continued higher production volumes, it will continue to achieve lower manufacturing costs by receiving more favorable terms from vendors.

- Develop dispensing devices for other markets. The Company intends to expand its existing product lines by developing new dispensing devices for markets other than lotteries. For example, the Company is developing and testing a device which dispenses stored value "smart" cards for possible use by the financial services industry to the extent that consumer use of smart cards develops in the future.

Products

The ITVM

In 1987, the Company's former President and current Vice Chairman, Edmund F. Turek, developed the technology for what the Company believes to be the first automated ITVM. This burster dispensing technology is a key component of the Company's ITVM for scratch-off instant lottery tickets and is protected by a patent that the Company acquired from Mr. Turek's family-owned corporation. See "Patents, Trademarks, and Copyrights" below.

The Company's ITVMs automatically dispense instant lottery tickets upon payment from the user. Unlike the products of some of the Company's competitors, the burster technology in the Company's ITVMs automatically separates one scratch-off instant ticket from another along the perforations between tickets to help prevent tearing of the tickets or scarring of the latex on the tickets. The Company's burster technology, which the Company believes to be the most technologically advanced scratch-off dispensing system in the ITVM industry, also enables the Company's ITVM to dispense and account for virtually any known type of scratch-off instant lottery ticket, allowing the use of a wide range of sizes, shapes, paper stocks or perforations, without the intervention of a lottery retailer or agent. This feature allows lotteries to purchase virtually any known type of scratch-off instant ticket from their instant ticket manufacturer without having to request from the manufacturer major alterations in the ticket perforations. For example, the Company's ITVM, unlike the products of the Company's competitors, can dispense recyclable scratch-off tickets without tearing or scarring the tickets. The Company believes that lotteries will increasingly require the use of recyclable tickets in their ITVMs. This feature also is particularly beneficial to foreign lottery jurisdictions that may use non-standard sizes, shapes and paper stocks. In addition, the ITVM for scratch-off tickets is faster than manual sales of scratch-off tickets as the ITVM's entire dispensing process is completed in less than 1.5 seconds once the ticket selector button has been pushed.

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The Company's ITVMs for scratch-off tickets have a proven record of reliability. Based on an analysis of actual field service data regarding the dispensing of approximately 55 million scratch-off instant tickets by the Company's ITVMs during a 48 week period, the Company determined that the Mean Time Between Failure of these ITVMs is approximately 3.78 years and that the Mean Time to Repair is approximately 15 minutes. The data indicated that these ITVMs dispense an average of 392,800 scratch-off instant tickets between failures. The Company believes that it has developed an ITVM that has proven to be reliable and that requires less maintenance than the products of its competitors. The Company believes that the reliability of its ITVM and the lower maintenance requirements distinguish the Company's ITVM for scratch-off tickets from those of its competitors.
See "Competition" below.

The Company's ITVMs for scratch-off tickets have the capacity to dispense tickets from one to twelve different bins. Because each bin can dispense tickets of different sizes, paper stocks and price levels, lotteries can sell scratch-off tickets for up to twelve different instant winner games with a single ITVM. The ITVM can accommodate up to 12,000 tickets in the twelve-game unit and can dispense all tickets in the bin without manual intervention. When all of the tickets in a bin have been dispensed, tickets can be easily reloaded by an employee of the retailer or agent. This is in contrast to the products of the Company's competitors, which the Company believes require the retailer or other agent to tape the last few tickets in each bin to the next pack of tickets provided by the retailer or other agent. The ability of the Company's ITVM to dispense every ticket in each bin not only facilitates the ticket reloading process but also enhances the accuracy of the inventory and accounting functions.

All of the Company's ITVMs accept bills in $1, $2, $5, $10 and $20 denominations and, in some applications, accept foreign currency. The size of the Company's ITVMs for scratch-off tickets varies from 69 inches tall, 28 inches wide and 24 inches deep for a twelve-game unit to 19.75 inches tall, 15.5 inches wide and 20.5 inches deep for a countertop unit.

All models are anchored to the floor or counter. The ITVMs typically are custom designed to meet any color and other appearance specifications that a lottery may desire. All models are Underwriters Laboratory ("UL(R)") listed and Federal Communications Commission ("FCC") approved, which ensures that the ITVM has passed nationally recognized safety standards and stringent requirements designed to preclude machine damage and personal injury due to non-approved components, devices, installation or application. The Company was the first manufacturer of ITVMs to obtain UL(R) listing and FCC approval for its ITVMs.

Each ITVM is standardized with an information display that provides the player with easy-to-read instructions on how to use the machine and gives the lottery retailer or agent the ability to read sales reports without printing the report. The ITVM can be ordered with a "BETA BRITE(R)" multi-color LED sign mounted on the top of the ITVM which is intended to increase attention to the machine and thereby increase ticket sales. The BETA BRITE(R) sign is programmed at the Company's manufacturing facility and can display any message the lottery may desire. The BETA BRITE(R) also may be programmed by the retailer or agent or can be programmed from the lottery headquarters by utilizing the Company's optional modem communications system. The Company currently is utilizing the BETA BRITE(R) on ITVMs installed throughout Arizona, Colorado, Florida, Georgia, Idaho, Indiana, New Hampshire, New Mexico and Rhode Island.

For security and durability purposes, each of the Company's ITVM cabinets is manufactured with 16 gauge and 11 gauge steel. The surface of the ITVM is coated with durable and fade resistant paints. The display windows are fabricated from a flame resistant, high impact polycarbonate sheet material. This material is shatter resistant, and to date to the knowledge of the Company, none of the Company's installed ITVMs has had a polycarbonate window broken or shattered. Additionally, to the knowledge of the Company, the cabinets have not had any fading, marring, scratching, chipping or rusting. All of the

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Company's ITVMs are manufactured with high security locks which are coded to prevent unauthorized duplication, and each ITVM is keyed separately, except for ITVMs deployed in Maryland where the Lottery desired a master key system. For further security, each of the Company's bill acceptor units must be accessed with a key unique to the particular acceptor unit.

All of the Company's ITVMs for scratch-off tickets utilize copyrighted software that can supply up to eleven different reports for accounting and inventory purposes. These reports can provide to the lottery and its retailers or agents a complete summary of daily sales, weekly sales, total sales, sales by game, current status of the machine, inventory of the product currently in the ITVM, the last three transactions of the ITVM and other types of information. The software system allows for a simple diagnostic test to identify any malfunction of the ITVM. The diagnostic mode communicates various information such as ticket size setting, status of electronics, status of each game and other information concerning the system software. The Company's ITVM software system may be programmed to the detail specifications of the specific lottery.

In 1995, the Company completed the development of a common electronic system to be incorporated in all of the Company's equipment, providing efficiency in development of common software as well as cost efficiencies in acquiring electronic components.

To dispense pull-tab instant lottery tickets, the Company's PTVM uses the same technology, design and specifications as are incorporated in the Company's PCDM. The Company's PCDM is described in detail below.

THE PCDM

Like the Company's ITVM for scratch-off tickets, the key component of the Company's PCDM is the dispensing technology. The Company has the exclusive right to the use of this patented dispensing technology, which it acquired from a company owned by Kazmier J. Kasper, a director of the Company. See "Item 13. Certain Relationships and Related Transactions."

Similar to the Company's ITVM for scratch-off tickets, the Company's PCDM automatically dispenses prepaid telephone calling cards upon payment from the user. Unlike the products of some of the Company's competitors, the dispenser technology in the Company's PCDMs automatically pulls one prepaid telephone calling card from the bottom of the stack of cards without the jamming that is associated with other dispensing processes. The Company's dispensing technology, which the Company believes to be the most technologically advanced dispensing system in the PCDM industry, also enables the Company's PCDM to dispense and account for virtually any known thickness of calling card without the intervention of the retailer. In addition, the PCDM is faster than manual sales of prepaid telephone calling cards as the PCDM's entire dispensing process is completed in less than 3 seconds once the selector button has been pushed.

The Company's PCDMs have the capacity to dispense cards from two to six different bins. The PCDM can accommodate up to 2,400 cards in the six bin unit and can dispense all prepaid telephone calling cards in the bin without manual intervention. When all of the cards in a bin have been dispensed, cards easily can be reloaded by an employee of the retailer. The ability of the Company's PCDM to dispense every card in each bin not only facilitates the card reloading process but also enhances the accuracy of the inventory and accounting functions.

All of the Company's PCDMs accept bills in $1, $2, $5, $10 and $20 denominations and, in some applications, accept foreign currency. The size of the Company's PCDMs varies from 66 inches tall, 26 inches wide and 19 inches deep for a 6-bin dispenser unit to 22 inches tall, 14 inches wide and 10 inches

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deep for a countertop unit. All models are anchored to the floor or counter, except that the two bin model may be mounted on an optional pedestal. All models are UL(R) listed and FCC approved. Each PCDM is standardized with an information display that provides the user with easy-to-read instructions on how to use the machine and gives the retailer the ability to read sales reports without printing the report.

For security and durability purposes, each of the Company's PCDM cabinets is manufactured with 16 gauge and 11 gauge steel. The surface of the PCDM is coated with durable and fade resistant paints. The display windows are fabricated from a flame resistant, high impact polycarbonate sheet material. To the knowledge of the Company, the cabinets have not had any fading, marring, scratching, chipping or rusting. All of the Company's PCDMs are manufactured with high security locks that are coded to prevent unauthorized duplication, and each PCDM is keyed separately. For further security, each of the Company's bill acceptor units must be accessed with a key unique to the particular acceptor unit.

All of the Company's PCDMs utilize copyrighted software that can supply up to nine different reports for accounting and inventory purposes. These reports can provide retailers a complete summary of daily sales, weekly sales, total sales, sales by bin, current status of the machine, inventory of the product currently in the PCDM, the last three transactions of the PCDM and other types of information. The software system allows for a simple diagnostic test to identify any malfunction of the PCDM.

Marketing and Sales

ITVMS

The Company markets its ITVMs to both domestic and international lotteries and their licensees or prime contractors. The Company attends lottery and gaming trade shows, maintains personal contact with lottery officials through its sales force of five employees and advertises in trade publications to increase its presence in the lottery industry.

The focus of the Company's marketing strategy is on the superior performance and reliability of its ITVMs, as well as continued competitive pricing. Information developed through actual field use and product field tests demonstrates that a significant factor in increasing instant ticket sales is the reliability of the ITVM. Increased maintenance visits impair the ITVM "uptime," which in turn reduce ticket sales. The Company believes that its ITVMs, based on actual field performance and product testing, are the most reliable and technologically superior in the industry. Management believes that actual field demonstrations comparing the Company's ITVM with those of its competitors is the Company's best method of marketing. The Company has been awarded contracts to provide ITVMs for nine of the last 11 state lotteries that have requested bid proposals and five of the six domestic ITVM contracts that were awarded in 1997.

The Company's ITVMs require preventive maintenance only twice a year. The ITVM "downtime" resulting from this semi-annual preventive maintenance averages approximately 20 minutes. On the other hand, the Company's principal competitor, On-Point Technology Systems, Inc. ("On-Point"), for example, recommends that preventive maintenance be performed on its ITVMs once a month. All of the Company's existing contracts which require the Company to provide preventive maintenance on its ITVMs provide for semi-annual preventive maintenance.

To further increase the likelihood of receiving ITVM orders from lotteries, the Company intends to offer additional and more flexible financing alternatives to the lotteries. The Company believes that many state lotteries, due to budget considerations, cannot afford the high capital costs required to purchase ITVMs. However, if the Company can provide attractive variations of its standard and percentage lease financing options for the lotteries, the lotteries can more affordably deploy ITVMs. The Company believes that these types of financing alternatives will prove to be increasingly popular.

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The Company's ability to generate additional revenues and earnings from deployments of its ITVMs will depend upon continued market acceptance of ITVMs. The Company intends to expand its marketing presence with the retail grocers associations, convenience store operators associations, retail stores at both the corporate and store levels, and other types of corporate or association member entities to familiarize these groups with the Company's ITVM. These retailers are the lotteries' distribution system for all scratch-off and pull-tab lottery tickets, and management believes that increased exposure to lottery retailers will be a significant factor in the Company's ability to expand the market for its lottery products. As the distribution system for all lottery products, lottery retailers may advise the lotteries with regard to such matters as new lottery products, improved marketing strategy and improved product distribution. In many lottery jurisdictions, retailer advisory boards provide input to the lotteries on various issues affecting the lottery. While the lotteries must abide by the established procurement laws of their respective jurisdictions in selecting an ITVM manufacturer, the lotteries may solicit the opinions of the lottery retailers concerning the ITVMs under consideration by the lottery because the retailers are directly affected by the selection decision. The Company believes that retailers' opinions may be a significant factor in a customer's decision regarding which manufacturer's ITVM to deploy in its instant ticket distribution system.

The Company will continue to participate in cooperative service arrangements with other lottery suppliers as the lotteries increasingly rely on these types of arrangements. These arrangements allow lotteries to reduce their operating costs while increasing lottery revenues. Additionally, these arrangements allow for a more efficient means for contracting products and services. The Company's ITVMs are deployed in Georgia and West Virginia pursuant to cooperative service arrangements between the Company and Scientific Games, Inc., which is a primary contractor for the Georgia and West Virginia Lotteries, and were deployed in New Jersey pursuant to a purchase agreement between the Company and GTECH Corporation, which is the on-line supplier to the New Jersey Lottery. Under these arrangements, the Company supplies ITVMs to Scientific Games, Inc. for use in Georgia and West Virginia and supply ITVMs to GTECH Corporation for use in New Jersey. The Company is responsible for installing, servicing and maintaining the ITVMs in Georgia but is not required to provide preventive maintenance or servicing for the ITVMs supplied for use in West Virginia and New Jersey. Management believes that the deployment of the Company's ITVMs in Georgia, West Virginia and New Jersey resulted in part from the Company's cooperative service arrangements with Scientific Games, Inc. and GTECH Corporation and that such cooperative service arrangements will prove to be increasingly attractive to both domestic and international lotteries in the future.

PCDMS

The Company has been marketing its PCDMs since late 1995 and to date has employed a marketing strategy that is similar to the strategy that it has used successfully to market its ITVMs. The focus of the Company's marketing strategy is on the superior performance and reliability of its PCDMs as well as on competitive pricing. The Company markets its PCDMs to both domestic and international providers of long distance telephone service. The Company attends telecommunications trade shows, maintains personal contact with telecommunications companies through its sales force of two employees and advertises in trade publications to increase its presence in the telecommunications industry.

The Company's ability to generate additional revenues and earnings from the deployment of its PCDMs will depend upon continued market acceptance of PCDMs. The Company intends to expand its marketing presence with the retail grocers associations, convenience store operators associations, retail stores at both the corporate and store levels, and other types of corporate or association member entities to familiarize these groups with the Company's PCDM. These retailers are the distribution system for prepaid telephone calling cards, and management believes that increased exposure to PCDM retailers will be a

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significant factor in the Company's ability to expand the market for its PCDM products. To further increase the likelihood of receiving PCDM orders from sellers of prepaid telephone calling cards, the Company intends to offer additional and more flexible financing alternatives.

Contracts

ITVMS

General. The Company's lottery contracts typically are entered into following a competitive bidding process. Once a lottery has determined to utilize ITVMs in its distribution network, the lottery usually will request proposals from ITVM providers. Lotteries within the United States typically follow a procedure whereby the lottery issues a Request for Proposal ("RFP") to determine the contract award for installation of ITVMs. The RFP generally seeks information concerning each company's products, cost of the products or services to be provided, quality of management, experience in the industry and other factors that the lottery may deem material to a contract award. The RFP also may specify product criteria and other qualifications or conditions that must be satisfied, such as UL(R) listing and FCC approval of the ITVM and in-state or minority supplier requirements. Generally, an evaluation committee comprised of key lottery staff members appraise the proposals based on an established point system, and the contract is awarded to the company with the most points.

The nature of the RFP process varies from jurisdiction to jurisdiction. The length of time that a lottery might take to award a contract can be difficult to predict, and delays in the contract award process are frequent and unpredictable. Additionally, the point system or the weighing of the various points varies from jurisdiction to jurisdiction, which often makes it difficult for the bidding companies to determine the relative importance of the various factors to be considered by the evaluation committee. In certain cases the contract award is challenged by the losing bidder, which can result in protracted legal proceedings for all parties.

The Company offers lotteries a choice of three types of contracts: (i) Standard Lease Agreements; (ii) Sales Agreements; and (iii) Percentage Lease Agreements. ITVM lease revenues as a percentage of the Company's total revenues were 47.3%, 63.3% and 67.3% in 1995, 1996 and 1997, respectively.

The Standard Lease Agreements provide that the lottery will pay a fixed monthly price per machine for a specific period of time. These agreements typically specify a number of years for the initial contract term with additional option periods at the election of the lottery. The lottery may award a separate service contract for the maintenance of the machines, incorporate the cost of service into the established monthly lease price or perform machine service themselves. The lotteries also may select a similar type of arrangement as described above to procure the necessary supply of replacement parts for the ITVMs.

As noted above, the lease payments provided for in the typical Standard Lease Agreement are fixed in most cases during the term of the agreement, and these agreements typically permit the lottery to order additional ITVMs at any time during the lease term. If the lottery orders a significant number of ITVMs near the end of the lease term, the Company would have to incur significant manufacturing costs but may receive lease payments for only a relatively short period of time through the remainder of the lease term. However, the Company believes that it is more likely that the lottery would elect to extend the lease term rather than return the ITVMs after only a short period of use.
Additionally, the Company is unable to pass along to the lottery any increase in its manufacturing and service costs during the term of the typical Standard Lease Agreement. In the case of a Standard Lease Agreement which provides for a short initial term (such as one year) with an option for the lottery to extend the lease term for additional one-year periods, if the lottery does not extend the initial lease term, the Company might incur a loss on the manufacture of the ITVMs leased to the lottery under the initial lease agreement.

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Sales Agreements typically provide that the lottery will buy a certain number of ITVMs over a specific period of time. Under the Sales Agreement, the lottery generally pays for the ITVMs when delivered and has complete ownership of the ITVMs. The lottery usually will contract with a vendor to maintain and service the ITVMs, although some lotteries provide the maintenance and service with their own service staffs. The lottery generally will enter into a parts replacement contract with the vendor for replacement parts.

All types of the ITVM contracts typically contain stringent installation, performance and maintenance requirements. Failure to perform the contract requirements may result in significant liquidated damages or contract termination. The Company has various contract performance standards to which it must adhere. To date, the Company has satisfied all of its contractual installation, performance and maintenance requirements and therefore has not had any contracts terminated by any lotteries.

The Company's lottery contracts also typically require the Company to indemnify the lottery, its officers and retailers for any liabilities arising from the operation of the ITVMs or any services provided by the Company. The Company typically is required to obtain liability insurance, fidelity insurance and performance and litigation bonds to protect itself and the lottery from potential liability. No such indemnification or insurance claims have ever been asserted against the Company.

The Company's contracts generally have an initial term of one to five years with options to extend the duration of the contracts for periods of between one and five years. The option extensions generally are at the lottery's discretion and are exercised under the same terms and conditions as the original contract. As of December 31, 1997, the initial term of nine of the Company's contracts had expired, and in each case, the lottery exercised its option to extend the term. The Company's contracts with lotteries, like most other types of state contracts, typically permit a lottery to terminate the contract upon 30 days written notice for any reason. Upon termination of a lease contract, the lottery would return the leased equipment to the Company. It is uncertain, however, whether the Company would be able to re-lease or sell any ITVMs that may be returned to the Company following the expiration or cancellation of a lease. To date, no lottery has terminated its contract with the Company. Upon termination of a contract, the lottery may award new contracts through a competitive bid process.

As noted above, the Company believes that 31 states and the District of Columbia utilize ITVMs in some manner as part of their instant ticket distribution system. The Company's ITVMs have been deployed in 22 of those states as well as five foreign jurisdictions, and three additional states and four foreign jurisdictions currently are testing the Company's ITVMs or have requested that the Company provide ITVMs for testing. Set forth below is certain information regarding the Company's contract status and the number of Company ITVMs sold or leased in each of these jurisdictions as of December 31, 1997. All of the Company's existing contracts, except for the contract with the Maryland Lottery, have provisions that allow the lotteries to order additional ITVMs in the future.

                                                               Type of                       No. of ITVMS
State                      Status of Contract Award            Contract                     Sold or Leased
-----                      ------------------------            --------                     --------------
Arizona                    Awarded in October 1993;            Standard Lease/                   222
                           renewed through June 1998,          Maintenance
                           with a six month renewal
                           at the option of the lottery

Colorado                   Awarded in June 1996; renewed       Standard Lease/                   487

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                           through June 2000                   Maintenance

District of Columbia       Awarded December 1997;              Standard Lease                     10
                           expires December 1998

Florida                    Awarded September 1996              Standard Lease                    500
                           expires June 1998 with two
                           one-year renewals at the option
                           of the lottery

Georgia (1)                Awarded in May 1993;                Standard Lease/                   502
                           renewed through May 2003            Maintenance

Idaho                      Purchases made by purchase          Sales                             185
                           orders in May and August 1995,
                           August 1996 and August 1997

Indiana                    Awarded in July 1995;               Standard Lease                    690
                           expires in October 1997, with
                           two one-year renewal at the
                           option of the lottery; first renewal
                           option has been exercised

Iowa                       Awarded in August 1994;             Standard Lease/                   531
                           expires in December 1998,           Maintenance
                           with two one-year renewals
                           at the option of the lottery

Kansas                     Awarded May 1997; expires           Standard Lease                     50
                           May 2000 with five one-year
                           renewals at the option of
                           the lottery

Kentucky                   Awarded in June 1991;               Sales                             912
                           renewed through February
                           1998, with two subsequent
                           one-year extensions at
                           the option of the lottery

Maine                      Awarded in July 1995; expires       Standard Lease/                   200
                           in July 1998, with two one-year     Maintenance
                           extensions at the
                           lottery's option

Maryland                   Awarded in September 1993;          Sales/Maintenance                 301
                           expires in September 1998;
                           additional contract awarded
                           that expires June 2003

Minnesota                  Awarded in December 1996;           Standard Lease/                    10
                           expires three years from            Maintenance

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                           acceptance of each ITVM,
                           with two one-year renewals at
                           the option of the lottery

New Hampshire              Awarded in August 1994;             Standard Lease                    250
                           renewed through June 2000

New Jersey (2)             Purchase order received in          Sales                             200
                           December 1996

New Mexico                 Awarded May 1997; expires           Standard Lease                    200
                           May 2002, with five one-year
                           renewals at the option of the
                           lottery

New York (3)               Awards of purchase contracts        Sales/                          2,554
                           made in May 1992 and January        Maintenance/
                           January 1993; deployment            Standard Lease
                           completed in June 1992 and
                           February 1993, respectively;
                           initial one-year purchase and
                           three-year maintenance contract
                           entered  into in March 1995, with
                           a one-year renewal option by the
                           lottery; initial five-year lease
                           contract awarded in January
                           1997 for up to 1,000 units,
                           with a one-year renewal option
                           as mutually agreed

Ohio                       Awarded in January                  Standard Lease/                  1,726
                           1992; extended in June 1993 and     Maintenance
                           June 1995; expired in June 1997;
                           new contract awarded April 1997;
                           extended through June 1999, with
                           two two-year extensions at the
                           option of the lottery

Oregon                     Purchase orders issued in May       Sales                              520
                           1995 and January 1997

Rhode Island (4)           Awarded in June 1994;               Standard Lease/                    170
                           renewed through June 1998,          Maintenance
                           with one one-year renewal
                           at the option of the lottery

Texas                      Awarded in January 1995;            Standard Lease/                  1,424
                           renewed through February            Maintenance
                           1999, with a one-year renewal
                           at the option of the lottery

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West Virginia (3)          Awarded in May 1992;                Sales                               55
                           initial deployment completed in
                           June 1992; additional units
                           deployed in April 1994

Barcelona, Spain (5)       Awarded in February 1994;           Standard Lease                      11
                           additional units deployed in
                           October 1995

Brazil                     Purchase order received in          Sales                                4
                           October 1996

Iceland                    Purchase orders issued in           Sales                               31
                           January and October 1997

Israel                     Purchase order issued in            Sales                               40
                           July 1997

Western Australia          Purchase order received in          Sales                                8
                           May 1995                                                            ------

                  Total Sold or Leased                                                         11,793


(1) The Company's contract is for the lease of ITVMs to Scientific Games, Inc., the primary contractor for the Georgia Lottery. In September 1994, the Company and Scientific Games, Inc. agreed to convert the contract from a Percentage Lease Agreement to a Standard Lease Agreement.

(2) The Company's contract is for the sale of 200 ITVMs to GTECH Corporation for use by the New Jersey Lottery, which were delivered in 1997.

(3) The Company's contract was for the sale of ITVMs to Scientific Games, Inc. for use by the New York and West Virginia Lotteries. The Company is not the sole manufacturer of ITVMs for the New York Lottery. The Company entered into a sales/maintenance contract in March 1995 directly with the New York Lottery, including maintenance of ITVMs previously provided. The West Virginia Lottery also currently is conducting field tests on the Company's PTVM.

(4) Effective October 1, 1995, the Company and the Rhode Island Lottery agreed to convert the contract from a Percentage Lease Agreement to a Standard Lease Agreement.

(5) The Company's contract is with Entitat Autonomas, which provides lottery services to various Spanish lotteries.


Substantially all of the Company's revenues are derived from its contracts with a limited number of state lottery authorities or their representatives for the lease, sale or service of ITVMs. During 1994 and 1995, contracts with the Ohio Lottery, the New York Lottery and Scientific Games, Inc. (the primary contractor for the Georgia Lottery) accounted for 83.3% and 72.9%, respectively, of the Company's revenues, and during 1996, contracts with the New York Lottery, the Ohio Lottery and the Texas Lottery

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accounted for 67.6% of the Company's revenues. During 1997, no single contract accounted for more than 20% of the Company's revenues.

PCDMS

Unlike the competitive bidding process applicable to the lotteries' awards of ITVM contracts, purchasers of PCDMs typically do not issue RFPs or otherwise mandate a competitive bidding process. Information regarding the Company and its PCDM, and information regarding a telephone company's product needs and criteria and other qualifications or conditions that must be satisfied, typically is exchanged on a less formal basis in sales presentations and subsequent meetings between representatives of the Company and representatives of the telephone company. Due to the often complex and highly structured organization of some telephone companies, the length of time that a company might take to decide whether to select the Company's PCDM can be difficult to predict and, similar to the lotteries' contract award process, delays in PCDM selection decisions can be frequent and unpredictable.

Unlike the Company's experience in the ITVM industry in which a lottery typically enters into a lease or sales contract with the successful bidder, most purchasers of the Company's PCDMs to date have ordered PCDMs solely through purchase orders rather than contracts, although several customers entered into a lease agreement for PCDMs. Like contracts with the lotteries, however, these purchase orders may contain stringent installation, performance and service requirements. As of December 31, 1997, the Company had sold 658 PCDMs and had 37 PCDMs under lease.

Manufacturing Process

The manufacturing process consists of purchasing component parts, assembling the ITVMs and PCDMs and then testing the final products. Generally, the Company's machines use components which are built to Company specifications and are available from multiple sources. The Company has a strict policy of product procurement that emphasizes quality, satisfactory inventory of raw materials, and cost. The Company has a primary vendor and secondary suppliers for most of its components, and the Company typically has been able to obtain adequate supplies of required components on a timely basis from its suppliers or, when necessary, from alternative sources of supply. However, certain important components, such as components of the Company's ITVM burster and PCDM dispensing mechanisms and its bill acceptor mechanism, currently are purchased from a single source. The purchase of components from single-source suppliers subjects the Company to certain risks, including the continued availability of suppliers, price increases, potential quality assurance problems and lead time considerations. Because other suppliers exist that can duplicate these components should the Company elect or be forced to use a different supplier, the Company does not believe that any such change in suppliers would result in the termination of a production contract. However, the Company could experience a delay of 30 to 60 days in the production of machines should it elect or be forced to use other suppliers for these components. Such a delay adversely could affect the Company's ability to make timely deliveries of machines and to obtain new contracts. The single-source supplier of certain components of the Company's burster mechanism, PTVM dispensing mechanism and PCDM dispensing mechanism is Algonquin Industries, Inc. Kazmier J. Kasper, a director of the Company, is the President and owner of Algonquin Industries. See "Item 13. Certain Relationships and Related Transactions."

The Company assembles the components utilizing a core group of manufacturing employees and, on an as needed basis, contracting with employment agencies for appropriately trained manufacturing labor. The use of temporary, contract manufacturing labor gives the Company the flexibility to meet the production schedules required by large orders.

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The Company's Quality Control Department has responsibility for measuring quality levels and overseeing appropriate corrective action in all areas of the business. This includes supplier performance, in-house manufacturing and field performance. The Quality Control Department is responsible for measuring part, operator and assembly quality performance at all stages of the production process, stopping the assembly line or stopping shipments if necessary to assure that quality standards are met. The Quality Control Department also is responsible for measuring vendor product quality and taking appropriate actions, including rejection and disposition of substandard material. The Quality Control Department also is responsible for vendor quality system evaluation and vendor disqualification if necessary to ensure superior product quality.

The Company's manufacturing facility is located in Cincinnati, Ohio and has the capacity to produce and provide inventory for approximately 250 machines per week. The Company believes that this facility is suitable and adequate for its current and anticipated manufacturing needs at the present time.

Research And New Product Development

Since its inception, the Company has developed many of the technological advancements used in the ITVM industry. The Company believes that its ITVM was the first to obtain UL(R) listing and FCC approval. The Company also believes that it was the first to (i) manufacture and deliver ITVMs under a lease contract agreement, (ii) offer a "random play" push button selector option through which the ITVM rather than the player randomly selects the game to be played and (iii) receive patent protection for the technology used in its ITVM burster dispensing mechanism.

The Company currently employs three engineers and two technicians for research and development but currently subcontracts the majority of its research and development projects to independent contractors to reduce costs. The Company's copyrighted software is upgraded continually to meet the different demands of the various lotteries. In many instances, after an ITVM feature has been developed for a specific lottery, it is incorporated into the product line as a standard feature of the machine. The Company retains proprietary rights in all such developments.

The Company's ITVM may be purchased with an optional modem communication system which allows lotteries to gather sales data from each ITVM on an hourly, daily, weekly or monthly basis, depending on the needs of the customer. This data includes the daily or weekly sales totals and breakdown of these totals by game, including the total tickets sold. The Company has developed software to enable each ITVM equipped with the system to communicate to the host system automatically if there is a malfunction with the ITVM, thus greatly enhancing the Company's ability to provide prompt service for the ITVM. The Company has developed software to enable an ITVM equipped with the system to communicate with the host computer if a ticket bin is empty, which allows the lottery to call the retailer or agent and inform them of the situation. Additionally, by utilizing this system with the optional BETA BRITE(R) message display, the lottery can change the message display on any or all of its ITVMs.

The Company has incorporated its patented pull-tab lottery ticket dispensing mechanism into a combination ITVM which also contains the Company's patented burster mechanism. The Company currently has six combination ITVMs under lease to the Iowa Lottery. The pull-tab dispensing mechanism also has been incorporated into the Company's PCDMs, and the Company believes that the ability of the mechanism to dispense a variety of thicknesses of prepaid telephone calling cards significantly differentiates the Company's PCDMs from those of its competitors.

In an effort to expand its product lines into new markets, the Company is developing and testing a device which dispenses stored value "smart cards." This product may be marketed in the future to the financial services industry to the extent that consumer use of smart cards develops in the future.

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Research and development expenditures were $145,310, $665,449 and $545,039 for 1995, 1996, and 1997, respectively. The Company expects that its research and development efforts for the foreseeable future will be conducted by both Company employees and independent contractors.

Customer Service and Product Repair

Typically, the Company or its subcontractors install and service the machines purchased or leased by the Company's customers. The Company also provides maintenance of the ITVMs leased or sold to certain lotteries. Additionally, the Company provides part replacement, repair and technical services for various customers that have leased or purchased the Company's ITVMs and PCDMs. Service is provided to the retailers by the Company's staff of trained service technicians and dispatchers after a customer's representative informs the Company of the problem via the Company's toll-free telephone service line. The service dispatcher either resolves the matter over the telephone or immediately dispatches one of the Company's service technicians to the machine's location. The modular design and manufacturing standards of the Company's machines enable the Company to conduct any necessary repairs and maintenance quickly and efficiently. The Company estimates that meantime for all repairs is less than 15 minutes after the Company's service technician arrives at the machine's location.

The Company believes, based on actual data collected from various customers that have installed the Company's ITVMs and PCDMs, that the Company's machines have experienced substantially fewer mechanical problems and machine failures than machines currently sold by other industry participants. The Company also believes that the superior performance of its ITVMs and PCDMs will assist in the increased acceptance of these products among lotteries and providers of long distance telephone service.

The Company generally grants a 360-day repair or replacement warranty covering all parts and components of its machines. However, the warranty period may vary depending on the bid specifications. In certain circumstances the Company may warrant the product for the complete life of the contract. In these instances the contract generally will be a lease with the Company retaining ownership of the machine. Provisions for estimated warranty costs are recorded at the time of sale and are periodically adjusted to reflect actual experience. See Note 1 of Notes to Financial Statements contained in the Company's 1997 Annual Report, which is filed as Exhibit 13 to this report.

Patents, Trademarks and Copyrights

The Company currently has four U.S. patents and five pending patent application relating to its ITVMs and has filed disclosure documents with the United States Patent and Trademark Office ("PTO"), all as described below.

The Company owns by assignment U.S. Patent No. 4,982,337 entitled "System for Distributing Lottery Tickets." The assignment is recorded at the PTO. This patent is for the Company's burster technology, which is the key component of the Company's ITVM. The patent expires no later than December 31, 2007. The Company believes this patent is essential to the Company's business. Additionally, the Company has developed an improvement to the burster technology disclosed in this patent and has U.S. and international patent applications pending on these improvements.

The Company has developed a new system designed specifically for retail sale of lottery tickets and other items at the retail point of sale. The system utilizes the Company's burster technology and includes other modular and distributed components that can be adapted for use at the point of sale. The Company has a pending patent application at the PTO on this technology.

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The Company was issued U.S. Patent No. 5,330,185 on July 19, 1994 for the "Method and Apparatus for Random Play of Lottery Games." This patent expires no later than March 30, 2013 and has been assigned to the Company, and the assignment is recorded at the PTO. The technology disclosed in this patent allows a lottery game user to select a random play button as opposed to selecting a specific game of a multiple game ITVM. Once the random play button is pressed, the ITVM selects the game to be played based upon a random number generation algorithm, thereby adding another element of chance to the lottery ticket purchase. The Company believes that this patent gives the Company a competitive advantage over other manufacturers that do not have ITVMs with similar capabilities. The patent for the random play feature is considered important but not essential to the Company's business.

The Company was issued U.S. Patent No. 5,472,247 on December 5, 1995, for a "Multi-Point High Security Locking Mechanism for Lottery Machines." This patent expires no later than July 18, 2014 and has been assigned to the Company, and the assignment is recorded at the PTO. Because of the threat of break-in and theft of cash and lottery tickets contained within the ITVMs, the machines must be secured against unauthorized break-in or theft. The technology disclosed in this patent is a locking mechanism which provides a number of resistance points, all of which function to impede the unauthorized opening of a door located on the chassis of the Company's ITVM. The patent for the multi-point, high security locking mechanism is considered important but not essential to the Company's business.

The Company was issued U.S. Design Patent No. 376,621 on December 17, 1996 for the Company's double-game countertop ITVM. This patent expires no later than December 17, 2010 and has been assigned to the Company, and the assignment is recorded at the PTO. The Company believes that this patent is important but not essential to the Company's business.

The Company has submitted an Information Disclosure Document to the PTO for the purpose of identifying technology relating to its "Software Release Control and Data Security for ITVMs." The technology allows secure remote transmissions of software updates and operations data between the ITVM and the Company or the respective lottery. The invention also includes a key management system to control the keys used to encrypt data sent to and decrypt the data received at the ITVM. The Disclosure Document was filed on April 28, 1993.

The dispensing technology used in the Company's PTVM and PCDM was developed by Algonquin Industries, Inc. and is licensed to the Company pursuant to an exclusive license agreement with Algonquin Industries. Algonquin Industries has been granted U.S. Patent No. 5,335,822 for this mechanism. Under the terms of the license agreement, the Company is the sole entity entitled to use this technology on its ITVMs. See "Item 13. Certain Relationships and Related Transactions."

The Company currently uses operating software to perform all functions required to dispense and account for instant lottery tickets and prepaid telephone calling cards. This software is a stand-alone program which does not require any other software to operate. The software is designed to allow updates to be made quickly and inexpensively. The software was designed by Future Designs, a subcontractor to the Company, and employees of the Company. Future Designs has assigned all of its right, title and interest in and to the software to the Company. The Company intends to continue to develop software using both employees and subcontractors who agree to assign the copyright to developed software to the Company.

The Company has obtained federal registration in the United States of the following trademarks: INTERLOTT, INTERLOTT and design, and INSTANT SUCCESS. The Company also has obtained registration of the trademark INTERLOTT in Benelux, Hungary, Mexico and Spain. The Company does not deem the trademarks to be critical to the future of its business.

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The Company enforces a policy requiring all of its employees and subcontractors to execute confidentiality and proprietary rights agreements at the commencement of their employment or contract for service with the Company. The agreements generally provide that all inventions or discoveries and all confidential information developed or made known to the employees or subcontractors during the term of their employment or contract for service will be assigned to the Company and will be kept confidential and not disclosed to third parties.

There can be no assurance that current or future patents and other intellectual property rights of the Company will afford meaningful protection of the Company's competitive position. Furthermore, the Company's competitors may have filed patent applications for, or have been issued patents relating to, products or technologies competitive with or superior to those of the Company. The scope and validity of others' patents, the extent to which the Company or its suppliers may be required to obtain licenses thereunder, and the availability and cost of any such licenses are unknown, and there is no assurance that the necessary licenses could be obtained on terms or conditions which would not have a material adverse effect upon the Company. If the Company's intellectual property rights are violated, the costs of litigation could be significant and could divert funds that otherwise would have been available for other purposes. Moreover, litigation concerning the alleged violation of intellectual property rights is inherently uncertain, and the claims and counterclaims that might be asserted against the Company, if successful, could have a material adverse effect upon the Company's financial condition and business operations.

Competition

Competition in the markets for the Company's ITVM and PCDM is based on a number of factors, including technological features, product quality and reliability, price, compatibility, ease of installation and use, marketing and distribution capabilities, product delivery time, and service and support. The Company is aware of four manufacturers of ITVMs and approximately forty manufacturers of PCDMs in the United States, and competition among these manufacturers is intense. Of the four ITVM competitors, the Company has the largest share of the ITVM market in the United States, followed by On-Point and two smaller manufacturers. The Company is not aware of any published data regarding market shares in the PCDM industry. The Company believes that of the forty PCDM competitors, Opal Manufacturing Co. has the largest PCDM market share in the United States, but there is no clear indication of the market shares of the remaining companies.

In addition, the ITVM and PCDM markets are relatively new markets that have grown rapidly, and additional domestic and foreign manufacturers, some of which have substantially greater resources and experience than the Company, may elect to enter these markets. The instant ticket market also may face competition from other types of lottery and gaming products, including particularly on-line lottery products. The long distance telephone market similarly may face competition from other types of communications products, including facsimile, e-mail and other on-line products.

The Company believes that its patented dispensing technologies make its ITVM and PCDM dispensing mechanisms technologically superior to the dispensing mechanisms of its competitors and that this is a significant competitive advantage for the Company. The Company also believes that its products have earned a strong reputation for their performance, reliability and cost effectiveness. To remain competitive, the Company believes that it will need to continue to incorporate new technological developments into its existing products and to develop new products, as well as to maintain a competitive price for its products. These efforts, together with the Company's continuing sales and marketing efforts, will be critical to the Company's future success. Although the Company believes that its current successes, coupled with its history of continued product enhancement and cost reduction, will enable it to compete favorably with its competitors, there can be no assurance that the Company will be able to maintain or improve its competitive position in the ITVM and PCDM markets.

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Government Regulation

ITVMS

Lotteries are not permitted in the various states and jurisdictions of the United States unless expressly authorized by legislation in the subject jurisdiction. Similarly, the commencement of ITVM sales and leasing in new jurisdictions requires authorizing legislation and implementing regulations at the state level. The Company cannot predict the nature of the regulatory process in any jurisdiction that may authorize the purchase and lease of ITVMs in the future. Any such regulatory process may be burdensome to the Company or its key personnel and stockholders and could include requirements that the Company would be unable to satisfy.

Currently, 37 states and the District of Columbia have enacted legislation to allow for the operation of a lottery, and 32 of these jurisdictions utilize ITVMs in some manner as part of their instant ticket distribution process. The operation of the lotteries in each of these jurisdictions is strictly regulated. The formal rules and regulations governing lotteries vary from jurisdiction to jurisdiction but typically authorize the lottery, create the governing authority, dictate the prize structure, establish allocation of revenues, determine the type of games permitted, detail appropriate marketing structures, specify procedures for selecting vendors and define the qualifications of lottery personnel. No assurance can be given that there will not be an adverse change in the lottery laws of any jurisdiction in which the Company does business. Although the Company believes that it is unlikely that states which have enacted legislation that expressly authorize the use of ITVMs will adopt legislation in the foreseeable future that prohibits the use of ITVMs, there can be no assurance that such legislation will not be adopted in one or more jurisdictions in the foreseeable future.

To ensure the integrity of the lottery, state laws provide for extensive background investigations of each of the lottery's vendors and their affiliates, subcontractors, officers, directors, employees and principal stockholders. These investigations generally require detailed disclosure on a continuous basis with respect to the vendors, affiliates, subcontractors, officers, directors, employees and principal shareholders and, in the event the lottery deems any of such persons to be unsuitable, the lottery may require the termination of such persons. The failure of any such persons associated with the Company to obtain or retain approval in any jurisdiction could have a material adverse effect on the Company. Generally, regulatory authorities have broad discretion when granting such approvals. Although the Company has never been disqualified from a lottery contract as a result of a failure to obtain any such approvals, no assurance can be given that such approvals will be obtained or retained in the future.

The Federal Gambling Devices Act of 1962 (the "Act") makes it unlawful, with certain exceptions, for a person or entity to transport any gambling devices across interstate lines unless that person or entity has first registered with the United States Department of Justice. Although the Company believes that it is not required to register under such Act, the Company has voluntarily registered under the Act and intends to renew its registration annually. The Act also imposes various record keeping and equipment identification requirements. Violation of the Act may result in seizure or forfeiture of equipment, as well as other penalties.

The Company may retain governmental affairs representatives in various jurisdictions of the United States to monitor legislation, advise the Company on contract proposals, and assist with other issues that may affect the Company. The Company believes it has complied with all applicable state regulatory provisions relative to disclosure concerning the activities of itself and its advisors. The Company is not dependent on any such representative for any material contract.

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International jurisdictions that operate lotteries also impose strict regulations. International regulations may vary from those in the United States. Additionally, international regulations frequently impose restrictions on foreign corporations doing business within the specific jurisdiction. As a result, the Company may contract with local representation or align itself with a local partner when pursuing international contracts.

Laws and regulations of individual states and countries are subject to change. The failure to comply with such laws and regulations could have an adverse impact on the operations of the Company.

PCDMs

The Company is not aware of any federal, state or local regulations that apply to the manufacture, lease or sale of PCDMs.

Backlog

The Company's backlog of ITVMs committed for production as of December 31, 1997 was approximately $4,250,000, which was equal to the total base lease payments or sales value for the 847 ITVMs that were committed for production but had not been shipped to the Maryland and Ohio Lotteries as of December 31, 1997. See "Lottery Contracts." At December 31, 1996, the backlog of ITVMs committed for production was approximately $1,097,400, which was equal to the total base lease payments or sales value for the 460 ITVMs that were committed for production but had not been shipped to the Colorado, Indiana, New York and Texas Lotteries as of December 31, 1996. It is anticipated that substantially all of the Company's backlog at December 31, 1997 will be shipped on or before June 30, 1998. The Company had no backlog of PCDMs committed for production at December 31, 1997.

The Company has entered into various lease or sales agreements that permit the lotteries, at their sole option, to lease or purchase up to a total of 1,100 additional ITVMs as of December 31, 1997. However, the Company does not include in backlog ITVMs that may be sold or leased under existing contracts unless the Company has received a firm order for the ITVMs. Due to the relatively large size of individual orders, the small number of customers and the long sales cycle of the lottery industry, management considers backlog to be an indicator of current activity and not necessarily predictive of future orders.

Employees

The Company utilizes a work force of full-time employees supported from time to time by temporary or contract manufacturing and engineering personnel. As of December 31, 1997, the Company had 128 full-time employees, of which 50 were manufacturing employees, 7 were engineering employees, 55 were service employees and 16 were executives or senior managers. Nine of the executives and senior managers were devoted to sales and seven were devoted to management and administration. The Company intends to increase sales and marketing personnel during 1998 through the addition of two employees, to increase engineering personnel through the addition of one employee and to increase management and administrative personnel through the addition of three employees.

The Company's business requires that it continue to attract and retain additional personnel with a variety of skills, especially with engineering and marketing expertise. Significant competition exists for such personnel, and there can be no assurance that the Company will be able to attract and retain personnel with the skills and experience needed to achieve and manage growth.

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No Company employees are represented by any union, and the Company believes that its relations with its employees are good.

ITEM 2. PROPERTIES

The Company's manufacturing and distribution facilities currently are located in a facility containing approximately 35,000 square feet of leased space in Cincinnati, Ohio. The facility is comprised of approximately 5,000 square feet of office space and approximately 30,000 square feet of manufacturing space with the capacity to produce and provide inventory for approximately 250 machines per week. The lease is for a fixed term through December 31, 1999.

Effective January 1, 1997, the Company entered into a lease for a second facility containing approximately 11,750 square feet of space located a very short distance from the current facility in Cincinnati. The second facility serves as the executive office of the Company housing the executive, administrative, sales, engineering and service personnel. The lease for the second facility also expires on December 31, 1999. The Company believes that these two facilities are suitable for and adequate to support its operations for the foreseeable future.

The Company also leases approximately 1,000 square feet of warehouse and office space in Alpharetta, Georgia for the purpose of storing and repairing ITVMs used in connection with the Georgia Lottery. Scientific Games, Inc. provides this space to the Company at no cost under the terms of the Company's contract with Scientific Games. The lease is effective for the entire term of the contract, which has an initial term that expires in May 1998. See "Item 1. Business -- Contracts -- ITVMs." The Company believes that this facility is suitable for and adequate to support its operations for the Georgia Lottery.

ITEM 3. LEGAL PROCEEDINGS

In January 1996, the Company filed a lawsuit now pending in the United States District Court for the Southern District of Ohio against Lottery Enterprises, Inc. ("LEI," which subsequently changed its name to On-Point Technology Systems, Inc.) to collect sums that the Company alleges are owed to it under an Agreement in Principle dated March 23, 1995, relating to the Company's potential acquisition of LEI by merger (the "Transaction"). The parties did not consummate the Transaction. The Agreement in Principle required LEI to reimburse the Company's reasonable out-of-pocket expenses incurred in connection with the Transaction in the event the parties failed to execute a definitive merger agreement within 120 days of March 23, 1995, and the primary reason that the parties did not execute a definitive merger agreement was other than a breach of the Agreement in Principle by the Company. The Agreement in Principle also required LEI to pay the Company a "breakup fee" in the event that, within one year after the termination or abandonment of the Transaction by LEI, LEI entered into a binding commitment to engage in a recapitalization, debt issuance or working capital financing other than in the ordinary course of business, and the primary reason for the termination or abandonment of the Transaction was other than termination or breach of the Agreement in Principle by the Company. The Company seeks the reimbursement of approximately $241,000 in out-of-pocket expenses and a breakup fee of approximately $988,000.

LEI denied any liability to the Company and also asserted counterclaims against the Company seeking unspecified money damages exceeding $500,000. LEI claimed that the Company competed unfairly with LEI and wrongfully interfered with LEI's business by misrepresenting LEI's financial condition to the Pennsylvania state lottery agency and by utilizing information about LEI received during the due diligence conducted in connection with the Transaction. LEI also claimed that it is entitled to

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recover from the Company unspecified costs and expenses that it incurred in connection with the Transaction and sought a declaration from the Court that it is not obligated to pay the Company a breakup fee under the Agreement in Principle.

The Court granted partial summary judgment in the Company's favor on the Complaint, ruling that within one year after the Transaction was abandoned or terminated, LEI did enter into a recapitalization, debt issuance or working capital financing other than in the ordinary course of business. The Court left open the question whether LEI abandoned or terminated the Transaction (as opposed to the Company), which will be determined at trial. The Court also left open the question of whether LEI is obligated to reimburse the out-of-pocket expenses incurred by the Company in connection with the Transaction. The Court also has granted summary judgment in the Company's favor on LEI's counterclaims for unfair competition and tortious interference.

The Company is unable to predict the likelihood of success on its remaining claims or on LEI's counterclaim. The Company is seeking approximately $240,000 in out-of-pocket expenses and $988,000 on its claim for the breakup fee, but is unable to predict how much, if any, of any judgment would be collectible. The Company also is unable to predict whether LEI will prevail on its counterclaims and, if so, the amount of damages that LEI might recover against the Company. The Company also is unable to predict the amount of any settlement that might be agreed upon by the parties in the future or the timing of any such events. However, the Company believes that LEI's remaining counterclaims are without merit and that any amount of any damages that ultimately may be awarded to LEI would not have a material adverse effect on the business, operations or financial condition of the Company.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted by the Company to a vote of its stockholders during the fourth quarter ended December 31, 1997.

ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT

Set forth below, in accordance with General Instruction G(3) to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K, is certain information regarding the executive officers of the Company.

L. Rogers Wells, Jr., age 60, is Chairman of the Board and Chief Executive Officer of the Company and has been the principal stockholder of the Company since purchasing 80% of the Common Stock of the Company in September 1992. Mr. Wells served as a director of the Company from September 1992, and as Chairman of the Board and Chief Executive Officer of the Company from October 1993, until his resignation from these positions in October 1994. He was re-elected to these positions in February 1995. Additionally, Mr. Wells owns American Materials, Incorporated, which assembles and distributes automobile and truck components and serves as a regional warehousing and distribution center for various businesses. Mr. Wells also owns International Investments, Inc. ("III"), which invests in and provides financing to various businesses, including the Company. See "Item 13. Certain Relationships and Related Transactions." Mr. Wells has been active in various other industries, including manufacturing, mining, explosives and banking. From 1987 through 1991, Mr. Wells served as Secretary of Finance and Administration for the Commonwealth of Kentucky, and from 1989 through 1991 served as Secretary to the Governor's Executive Cabinet. During his tenure as Secretary of Finance and Administration, Mr. Wells served as Chairman of various finance and development authorities, including the Kentucky Rural Economic Development Authority, the Kentucky Infrastructure Authority and the Kentucky Housing Corporation.

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Edmund F. Turek, age 71, served as President and a director of the Company from February 1990 until May 1997 and served as Chairman of the Board and Chief Executive Officer of the Company from February 1990 to September 1992. In May 1997, Mr. Turek became Vice Chairman of the Company and continued to serve as a director. Mr. Turek began to develop the Company's ITVM in 1987 and has guided the product through six generations to the current model. Mr. Turek was Vice President of Peripheral Products in the computer division of SCI Systems, Inc. from 1984 to 1989 where he developed business opportunities in the commercial market for the design and manufacture of computer products. From 1953 to 1984, Mr. Turek held management, product development and operations positions with various companies in the computer and aerospace industries.

David F. Nichols, age 36, has been President of the Company since May 1997 and was named a director in December 1997. Mr. Nichols served as Senior Vice President of Sales and Marketing of the Company from August 1994 to May 1997 and as Vice President-Operations of the Company from March 1993 until August 1994. From December 1991 to December 1992, he was Executive Director of the Board of Tax Appeals of the Commonwealth of Kentucky. From March 1990 to December 1991, he was Principal Assistant to the Secretary of Finance and Administration for the Commonwealth of Kentucky, and from March 1989 to March 1990, he was Principal Assistant to the Kentucky Office for Social Security. In these two capacities, he advised senior agency officials on policies, programs and operations of the agency and served as a liaison with the state legislature and other elected officials. From June 1988 to December 1988, he was Deputy Director of the Kentucky Democratic Party.

Jerome J. Cain, age 53, has been Chief Financial Officer of the Company since 1992. From 1979 until 1991, he was Vice President-Finance and Administration of American Sign and Marketing Services, Inc., a sign manufacturing company. From 1972 to 1979, he was Controller of Lockwood Manufacturing Company, a sheet metal fabricating company. Mr. Cain also served as an auditor and management consultant with Coopers & Lybrand, certified public accountants. Mr. Cain is a certified public accountant.

Thomas W. Stokes, age 34, has been Vice President of the Company since May 1997. Mr. Stokes served as Director of Operations from January 1996 to May 1997 and as Purchasing Manager from March 1993 to December 1995. From 1988 to 1992, he served as unit controller for a food management company.

The executive officers of the Company are appointed by and serve at the discretion of the Board of Directors.

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