Hydra Industries Acquisition Corp. (HDRAU) SEC Quarterly Report (10-Q) for Q4 2017

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2017

For the transition period from __________ to __________

Commission File Number: 001-36689

INSPIRED ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code:   (646) 565-3861

(Former name or former address, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   ☒   No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes   ☒    No    ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company.  See definitions of "large accelerated filer", "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes    ☐    No   ☒

As of February 5, 2018, there were 21,478,775 shares of the Company's common stock issued and outstanding.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

The accompanying notes are an integral part of these condensed consolidated financial statements.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except share and per share data)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT

(in thousands, except share data)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Company Description and Nature of Operations

Inspired Entertainment, Inc. (f/k/a Hydra Industries Acquisition Corp.) (the "Company," the "group," "we," "our," and "us") is a global business-to-business gaming technology company, supplying Virtual Sports, Mobile and Server Based Gaming ("SBG") systems to regulated lottery, betting and gaming operators worldwide. We provide end-to-end digital gaming solutions on our proprietary and secure network, which accommodates a wide range of devices, including land-based gaming machine terminals, mobile devices such as smartphones and tablets and online computer and social applications.

The Company was formed in Delaware on May 30, 2014 under the name Hydra Industries Acquisition Corp. as a "blank check company" for the purpose of acquiring, through a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, recapitalization or other similar business transaction, one or more operating businesses or assets. On December 23, 2016 (the "Closing Date"), the Company consummated a business combination by acquiring Inspired Gaming Group pursuant to a share sale agreement dated as of July 13, 2016 (the "sale Agreement"), by and among the Company and those persons identified on Schedule 1 to the Sale Agreement, including DMWSL 633 ("Inspired"), DMWSL 632 Limited and Gaming Acquisitions Limited. Pursuant to the Sale Agreement, the Company acquired all of the outstanding equity and shareholder loan notes of Inspired Gaming Group. We refer to such acquisition and to the other transactions contemplated by the Sale Agreement, collectively, as the "Business Combination" or the "Merger".

Management Liquidity Plans

As of December 31, 2017, the Company's cash on hand was $10,989 and the Company had a working capital deficit of $23,377. The Company recorded net losses of $4,155 and $22,383 for the three months ended December 31, 2017 and 2016, respectively. The net losses arose principally due to acquisition related expenses, interest on shareholder loan notes in the prior year, which are no longer a liability of the Company following the Merger, and non-cash items, including stock-based compensation. Historically, the Company has generally had positive cash flows from operating activities and has relied on a combination of cash flows provided by operations and the incurrence of debt and/or the refinancing of existing debt to fund its obligations. The working capital deficit of $23,377 includes non-cash settled items of $12,071 for the earnout liability and $10,912 of deferred income, current. Management currently believes that the Company's cash balances on hand, cash flows expected to be generated from operations, ability to control and defer capital projects and borrowings available under the Company's credit facilities will be sufficient to fund the Company's net cash requirements through February 2019.

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and pursuant to the instructions to Form 10-Q and Article 8 of Regulation S-X of the United States Securities and Exchange Commission ("SEC"). Certain information or footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a comprehensive presentation of financial position, results of operations, or cash flows. It is management's opinion, however, that the accompanying unaudited interim condensed consolidated financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.

The accompanying unaudited interim condensed consolidated financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto for the periods ended September 30, 2017, September 24, 2016 and September 26, 2015. The financial information as of September 30, 2017 is derived from the audited consolidated financial statements presented in the Company's Annual Report on Form 10-K filed with the SEC on December 4, 2017. The interim results for the three months ended December 31, 2017 are not necessarily indicative of the results to be expected for the year ending September 30, 2018 or for any future interim periods.

The Company changed its reporting year end from a 52-week period ending on the last Saturday in September to a September 30 year end, commencing with the year ended September 30, 2017. Accordingly, the period ended December 31, 2016 includes the results of operations for the Company for the period from September 25, 2016 through December 31, 2016.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Principles of Consolidation

All monetary values set forth in these unaudited interim condensed consolidated financial statements are in US Dollars ("USD") unless otherwise stated herein. The accompanying unaudited interim condensed consolidated financial statements include the results of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Foreign Currency Translation

For most of our operations, GBP is our functional currency. Our reporting currency is the U.S. Dollar. We also have operations where the local currency is the functional currency, including our operations in mainland Europe and South America. Assets and liabilities of foreign operations are translated at period-end rates of exchange, equity is translated at historical rates of exchange and results of operations are translated at the average rates of exchange for the period. Gains or losses resulting from translating the foreign currency financial statements are recorded as a separate component of accumulated other comprehensive loss in stockholders' deficit. Gains or losses resulting from foreign currency transactions are included in other (expense), net in the condensed consolidated statements of operations and comprehensive loss.

Reclassification 

Certain prior year amounts were reclassified to conform to the current year's presentation. These reclassifications have no effect on the financial position or results of operations reported as of and for the period ended December 31, 2016. 

Use of Estimates 

The preparation of unaudited interim condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates these estimates, including those related to the revenue recognition for contracts involving software and non-software elements, allowance for doubtful accounts, inventory reserve for net realizable value, goodwill and intangible assets, useful lives of long-lived assets, stock-based compensation, valuation allowances on deferred taxes, earnout liability, derivative liabilities, commitments and contingencies and litigation, among others. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. We regularly evaluate these significant factors and make adjustments when facts and circumstances dictate. Actual results may differ from these estimates. 

Recently Issued Accounting Standards 

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09 (ASC 606), "Revenue from Contracts with Customers," which was subsequently modified in August 2015 by ASU No. 2015-14, "Revenue from Contracts with Customers: Deferral of the Effective Date" ("ASU 2014-09"). As a result, ASU No. 2014-09 is effective for fiscal years and interim periods within those years beginning after December 15, 2017. The core principle of ASU No. 2014-09 is that companies should recognize revenue when the transfer of promised goods or services to customers occurs in an amount that reflects what the company expects to receive. It requires additional disclosures to describe the nature, amount, timing and uncertainty of revenue and cash flows from contracts with customers. In 2016 and 2017, the FASB issued additional ASUs that clarify the implementation guidance on principal versus agent considerations (ASU 2016-08), on identifying performance obligations and licensing (ASU 2016-10), and on narrow-scope improvements and practical expedients (ASU 2016-12), as well as on the revenue recognition criteria and other technical corrections (ASU 2016-20, ASU 2017-13 and ASU 2017-14). The Company will adopt the standard on October 1, 2019, which may result in a cumulative-effect adjustment for deferred revenue to the opening balance sheet for 2017 and the restatement of the financial statements for all prior periods presented. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.

Accounts receivable consist of the following:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Inventory consists of the following:

Component parts include parts for gaming terminals. Included in component parts are reserves for excess and slow-moving inventory of $435 and $419 as of December 31, 2017 and September 30, 2017, respectively. Our finished goods inventory primarily consists of gaming terminals which are ready for sale.

Prepaid expenses and other assets consist of the following:

Depreciation and amortization expense amounted to $4,792 and $4,638 for the three months ended December 31, 2017 and 2016, respectively.

Software development costs, net consisted of the following:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

During the three months ended December 31, 2017, the Company capitalized $4,343 of software development costs. Amounts in the above table include $1,473 and $2,676 of internal use software at December 31, 2017 and September 30, 2017, respectively.

The total amount of software costs amortized was $3,926 and $1,749 for the three months ended December 31, 2017 and 2016, respectively. There were no software costs written down to net realizable value for the three months ended December 31, 2017 and 2016. The weighted average amortization period was 3.2 years for the three months ended December 31, 2017 and 2016.

The estimated software amortization expense for the years ending September 30 are as follows:

The following tables present certain information regarding our intangible assets. Amortizable intangible assets are being amortized on a straight-line basis over their estimated useful lives of ten years with no estimated residual values, which materially approximates the expected pattern of use.

Aggregate intangible asset amortization expense amounted to $842 and $781 for the three months ended December 31, 2017 and 2016, respectively.

The estimated intangible asset amortization expense for the years ending September 30 are as follows:

Goodwill

The difference in the carrying amount of goodwill at December 31, 2017 and September 30, 2017 (amounting to $361), as reported in the accompanying unaudited interim condensed consolidated balance sheets is attributable to foreign currency translation adjustments.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Accrued expenses consist of the following:

Other liabilities consist of the following:

Outstanding Debt and Capital Leases

The following reflects outstanding debt and capital leases as of the dates indicated below:

The Company is in compliance with all relevant covenants and the long term debt portion is correctly classified as such in line with the underlying agreements. 

Long term debt for the years ending September 30 matures as follows:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset and liability in an orderly transaction between market participants at the measurement date. We estimate the fair value of our assets and liabilities utilizing an established three-level hierarchy. The hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date as follows:

The fair value of our financial assets and liabilities is determined by reference to market data and other valuation techniques as appropriate. We believe the fair value of our financial instruments, which are principally cash, accounts receivable, prepaid expenses and other current assets, accounts payable and other long term liabilities, approximates their recorded values. 

For each period, derivative financial instrument assets and liabilities measured at fair value on a recurring basis are included in the financial statements as per the table below.

Level 3 liabilities are valued using unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the derivative liabilities. For fair value measurements categorized within Level 3 of the fair value hierarchy, the Company's Chief Financial Officer, who reports to the Chief Executive Officer, determines its valuation policies and procedures. The development and determination of the unobservable inputs for Level 3 fair value measurements and fair value calculations are the responsibility of the Company's Chief Financial Officer and is approved by the Chief Executive Officer.

Level 3 financial liabilities consist of the earnout liability for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation. Changes in fair value measurements categorized within Level 3 of the fair value hierarchy are analyzed each period based on changes in estimates or assumptions and recorded as appropriate (see Note 12).

At December 31, 2017 and September 30, 2017, there were no transfers in or out of Level 3 from other levels in the fair value hierarchy.

Pursuant to the Sale Agreement discussed in Note 2, an earnout payment of up to 2,500,000 shares of the Company's common stock, subject to certain customary anti-dilution adjustments (the "Earnout Consideration") shall be paid to the previous owners of Inspired (the "Selling Group") and will be determined based on the financial performance of the Company's businesses in six specific countries, China, Colombia, Greece, Norway, Spain and Ukraine (collectively, the "Earnout Jurisdictions"), as measured by earnings before interest, taxes, depreciation and amortization ("EBITDA") for the twelve months ending September 30, 2018 (the "Earnout Period"). If such EBITDA is equal to or greater than £15,000 ($20,253), the Selling Group will receive an aggregate of 2,500,000 shares of common stock. If such EBITDA is less than £15,000 ($20,253), the Selling Group will receive the number of shares equal to the product of (x) 2,500,000 and (y) a fraction, the numerator of which is such EBITDA and the denominator of which is £15,000 ($20,253).

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

In accordance with ASC 815, "Derivatives and Hedging" ("ASC 815"), the earnout shares are not considered indexed to the Company's own stock and therefore are accounted for as a liability with fair value changes being recorded in the condensed consolidated statements of operations and comprehensive loss. The fair value of the Earnout Consideration is calculated using a Monte Carlo simulation to estimate the variance and relative risk of achieving future EBITDA during the Earnout Period in the Earnout Jurisdictions. This model is a discrete-time model that allows for sources of uncertainty, simulates the movements of the underlying metric and calculates the resulting derivative value for each trial. Such simulations are performed for a number of trials and the average value across all trials is determined in order to arrive at the concluded value of such derivative. The Earnout Consideration was valued at $12,071 and $16,728 at December 31, 2017 and September 30, 2017, respectively. 

The key assumptions in applying the Monte Carlo simulation include the Earnout Period EBITDA in the Earnout Jurisdictions for the period ending September 30, 2018, a risk-adjusted discount rate of 13.3% as of December 31, 2017, a standard deviation of 49.3% as of December 31, 2017 (based on the expected standard deviation of the Earnout Period EBITDA), a normal distribution of Earnout Period EBITDA and a Monte Carlo simulation run 100,000 times.

Significant increases or decreases to any of these inputs in isolation would result in a significantly higher or lower liability, with a higher liability capped by the contractual maximum Earnout Consideration obligation. Ultimately, the liability will be equivalent to the amount paid in shares, and the difference between the fair value estimate and amount paid will be recorded in earnings.

The following table provides a reconciliation of the beginning and ending balances for the earnout liability measured using significant unobservable inputs (Level 3):

On December 22, 2016, the Company's Board of Directors adopted the Inspired Entertainment, Inc. Second Long-Term Incentive Plan (the "Second Incentive Plan") subject to approval by the Company's stockholders, which had not yet been sought or obtained as of December 31, 2017. The Second Incentive Plan initially authorized 200,000 shares to be issued pursuant to grants thereunder and was principally intended to provide a mechanism through which certain management bonuses due in cash upon consummation of the Merger could be paid partially in stock in order to preserve liquidity in the Company. Under such arrangement, members of management entitled to cash bonuses on the Closing Date of the Merger agreed to accept 50% of the bonuses due in cash and 50% in restricted stock units ("RSUs") under the Second Incentive Plan. Such awards have a scheduled distribution date of December 23, 2019, the third anniversary of the Merger (the "Management Bonus RSUs").

On December 13, 2017, the Board of Directors approved an increase in the number of shares available under the Second Incentive Plan by 1,100,000 shares, bringing the total shares available to be issued to 1,300,000 shares. Such increase was authorized in order to grant 926,272 RSUs to the Company's Executive Chairman and 150,000 RSUs to the Company's Chief Strategy Officer following the cancellation of the awards of restricted stock ("RSAs") covering the same number of shares that had been granted to them in January 2017 under the Company's stockholder approved 2016 Long-Term Incentive Plan (the "2016 Incentive Plan") (see Note 14). The new RSUs (the "Additional RSUs") vest upon the earliest of a transformational acquisition by the Company (as defined in the award agreement), the respective recipient's continued service through December 31, 2019, a change in control of the Company or the respective recipient's death, disability or termination without cause. The awards are subject to clawback provisions extending for three years following the settlement of the awards.

The terms governing all outstanding awards under the Second Incentive Plan would require the Company to settle the awards in cash rather than shares in the event the Company's stockholders have not approved the Second Incentive Plan by the date specified in the relevant recipient's award agreement (e.g., December 23, 2019 in the case of the Management Bonus RSUs and December 31, 2019, or such earlier vesting date as may occur, in the case of the Additional RSUs). Such cash payment would be based on the volume weighted average price of the Company's common stock over the 30 trading days prior to such settlement date. In connection with such cash payment, the recipient's award of RSUs would be cancelled. 

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

The obligation to settle awards under the Second Incentive Plan has been deemed to be a derivative liability due to the potential cash settlement provision which is not within the Company's control and, as a result, the obligation is accounted for as a derivative liability with fair value changes being recorded in the condensed consolidated statements of operations and comprehensive loss. The fair value of the liability is calculated based on the value of the underlying common stock. Until stockholder approval is obtained, awards under the Second Incentive Plan are not considered issued and outstanding.

As of December 31, 2017, the Board of Directors had approved grants under the Second Incentive Plan totaling 1,184,186 RSUs, of which 1,136,458 RSUs were issued and outstanding as of December 31, 2017 and scheduled to be settled on the three-year anniversary of the Merger (i.e., December 23, 2019). The activity during the quarter ended December 31, 2017 consisted of the grant of the 1,076,272 Additional RSUs discussed above and the cancellation in November 2017 of awards under the Second Incentive Plan totaling 12,560 RSUs upon termination of his employment in consideration of the Company agreeing to settle his award in cash. Since the derivative liability associated with the award to this participants was settled, the Company reclassified the fair value of the derivative liability amounting to $126. The settlement amount paid in cash was approximately $132 and the difference between the fair value of the derivative liability at the settlement date and the amount paid in cash was recorded as an adjustment to additional paid in capital.

The cancellation of the RSAs and concurrent granting of the Additional RSUs is considered to be a modification of the awards and resulted in the original classification of the awards as an equity instrument being switched to a classification as a liability instrument (as the RSAs were awarded under the stockholder approved 2016 Incentive Plan and the award terms did not contain the potential cash settlement feature applicable to Additional RSUs awarded under the Second Incentive Plan). Accordingly, on the date of the modification, $1,482 of previously recognized compensation expense was reclassified from additional paid in capital to derivative liability. The fair value of the Additional RSUs on the date of grant was $10,763, of which $2,105 was recorded as compensation expense during the three months ended December 31, 2017 and $3,516 was recorded as a derivative liability at December 31, 2017.

2016 Incentive Plan

As described in Note 13, in December 2017, the Company's Board of Directors granted the Executive Chairman and Chief Strategy Officer 1,076,272 RSUs under the Second Incentive Plan following the cancellation of the awards of RSAs covering the same number of shares that had been granted to them in January 2017 under the Company's stockholder approved 2016 Incentive Plan.

Stock-based compensation is recognized as an expense on a straight-line basis over the requisite service period, which is generally the vesting period. As of December 31, 2017, there were 1,112,436 shares of non-vested restricted stock and RSUs outstanding.

The company recognized stock-based compensation expense as follows:

The accumulated balances for each classification of comprehensive loss (income) are presented below:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Basic loss per share ("EPS") is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period, excluding the effects of any potentially dilutive securities. Diluted EPS gives effect to all dilutive potential of shares of common stock outstanding during the period, including stock options, restricted stock and warrants, using the treasury stock method, and convertible debt or convertible preferred stock, using the if-converted method. Diluted EPS excludes all dilutive potential of shares of common stock if their effect is anti-dilutive.

The computation of diluted EPS excludes the common stock equivalents of the following potentially dilutive securities because their inclusion would be anti-dilutive:

On December 22, 2017 several significant changes to the U.S. tax code were signed into law under the Tax Cuts and Jobs Act (the "Act"). Included amongst such changes is a reduction of the US corporate tax rate from 35% to 21%. Most of the effective dates of provisions in the Act are based on tax years beginning after December 31, 2017. Accordingly, many of the related provisions should not impact Inspired until its fiscal year beginning October 1, 2018. Nonetheless, the Company continues to evaluate the impact of the Act on the tax provision.

Income taxes are accounted for under the asset and liability method. Our provision for income taxes is principally based on current period income (loss), changes in deferred tax assets and liabilities and changes in estimates with regard to uncertain tax positions. We estimate current tax expense and assess temporary differences resulting from differing treatments of items for tax and accounting purposes using enacted tax rates in effect for each taxing jurisdiction in which we operate for the period in which those temporary differences are expected to be recovered or settled. These differences result in deferred tax assets and liabilities. Our total deferred tax assets are principally comprised of depreciation and net operating loss carry forwards.

The effective income tax rate for the three months ended December 31, 2017 and 2016 was (0.80%) and (0.23%), respectively, resulting in a ($33) and ($51) income tax expense, respectively. The income tax expense for the three months ended December 31, 2017 differs from the amount that would be expected after applying the statutory U.S. federal income tax rate primarily due to the impact of the U.S. statutory tax rate change on deferred tax assets and liabilities, changes in the valuation allowance for deferred taxes and the net losses generated by the Company's non-US foreign subsidiaries. The income tax expense for the three months ended December 31, 2016 differs from the amount that would be expected after applying the statutory U.S. federal income tax rate primarily due to the changes in the valuation allowance for deferred taxes and the net losses generated by the Company's non-US foreign subsidiaries.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considered the scheduled reversal of deferred income tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the consideration of these items, management determined that it is more likely than not that the Company will not realize the deferred income tax asset balances and therefore, recorded a full valuation allowance of $49,841 as of December 31, 2017.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

The utilization of the Company's pre-Merger net operating losses may be subject to a substantial limitation due to the "change of ownership provisions" under Section 382 of the Internal Revenue Code and similar state provisions. Such limitation may result in the expiration of some or all of the net operating loss carryforwards before their utilization.

We occupy office space leased by a company affiliated with our Executive Chairman. We acquired inventory and paid maintenance expenses for the office.

Legal Matters

From time to time, the Company is involved in legal matters arising in the ordinary course of business. While the Company believes that such matters are currently not material, there can be no assurance that matters arising in the ordinary course of business for which the Company is, or could be, involved in litigation, will not have a material adverse effect on its business, financial condition or results of operations.

On June 30, 2017, Martin E. Schloss, the former Executive Vice President, General Counsel and Secretary of the Company, filed a lawsuit in the Supreme Court of the State of New York, County of New York, naming as defendants the Company and A. Lorne Weil, alleging a breach by Mr. Weil of a purported oral contract to name Mr. Schloss as general counsel of the entity surviving any initial business combination effected by the Company, and asserting unjust enrichment claims against Mr. Weil and the Company and quantum meruit claims against the Company to receive additional compensation for Mr. Schloss's past services to the Company prior to its initial business combination, seeking unspecified damages in an amount allegedly expected by the plaintiff to be no less than $1 million. The Company believes that any damages if Mr. Schloss were to prevail would not be material to the Company, and is contesting the matter vigorously. Both the Company and Mr. Weil have moved to dismiss Mr Schloss' suit. Oral argument on the motions was held on January 17, 2018 and the court's decision on the motions remains pending.

We operate a scheme which is comprised of a separately managed defined benefit section and a defined contribution section. The defined benefit section is closed to future accruals for services rendered to the Company. We estimate that $3,296 will be contributed to the pension plan during the year ending September 30, 2018.

The total amount of employer contributions paid during the three months ended December 31, 2017 amounted to $869. We expect to pay $2,427 during the remaining part of the fiscal period.

For the three months ended December 31, 2017 and 2016, the components of total periodic benefit costs were as follows:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

The Company operates its business along two operating segments, which are segregated on the basis of revenue stream: Server Based Gaming and Virtual Sports. The Company believes this method of segment reporting reflects both the way its business segments are managed and the way the performance of each segment is evaluated.

The following tables present revenue, cost of sales, excluding depreciation and amortization, selling, general and administrative expenses, depreciation and amortization, stock-based compensation expense and acquisition related transaction expenses, operating profit/(loss), total assets and total capital expenditures for the three months ended December 31, 2017 and 2016, respectively, by business segment. Certain unallocated corporate function costs have not been allocated to the Company's reportable operating segments because these costs are not allocable and to do so would not be practical. Corporate function costs consist primarily of selling, general and administrative expenses, depreciation and amortization, capital expenditures, cash, prepaid expenses and property and equipment and software development costs relating to corporate/shared functions.

Segment Information

Three Months Ended December 31, 2017

Three Months Ended December 31, 2016

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

Geographic Information

Geographic information for revenue is set forth below:

Geographic information of our non-current assets excluding goodwill is set forth below:

Software development costs are included as attributable to the market in which they are utilized.

During the three months ended December 31, 2017, there were three customers that represented at least 10% of revenues, accounting for 27%, 14% and 10% of the Company's revenues. During the three months ended December 31, 2016, two customers represented at least 10% of revenues, accounting for 30% and 11% of the Company's revenues. All these customers were served by both the Server Based Gaming and Virtual Sports segments. 

At December 31, 2017, two customers represented at least 10% of accounts receivable, accounting for 17% and 13% of the Company's accounts receivable. At September 30, 2017, two customers accounted for 26% and 13% of the Company's accounts receivable.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2017

(in thousands, except share and per share data)

(Unaudited)

The Company evaluates subsequent events and transactions that occur after the balance sheet date up to the date that the financial statements were issued. Other than as described below, the Company did not identify subsequent events that would have required adjustment or disclosure in the consolidated financial statements. 

On January 17, 2018, the Company and three holders of shares of the Company's common stock, Landgame  S. à.r.l. ("Landgame"), Ares Capital Europe Limited and Rossoff & Company LLC (collectively, the "Selling Stockholders"), entered into an underwriting agreement (the "Underwriting Agreement") with Morgan Stanley & Co. LLC, as underwriter (the "Underwriter") pursuant to which the Underwriter agreed to purchase from the several Selling Stockholders a total of 4,500,000 shares of common stock at a price of $7.95 per share (the "Selling Stockholder Offering"). The Company will not receive any proceeds from the sale of common stock by the Selling Stockholders. The transaction closed on January 22, 2018. Within 30 days after the date of the Underwriting Agreement, the Underwriter, at its own election, may choose to purchase up to an additional 675,000 shares of common stock from Landgame  S. à.r.l.

In the Underwriting Agreement, the Company made certain customary representations and warranties and entered into certain customary covenants and agreements, including an agreement to indemnify the Underwriter and the Selling Stockholders against certain liabilities that could arise under the Securities Act of 1933, as amended (the "Securities Act"), and an agreement to contribute in certain circumstances to payments that the Underwriter or any of the Selling Stockholders could be required to make in respect of any such liabilities. The Company also agreed that, for a period of 90 days after January 17, 2018, it would refrain from offering or selling common stock or any other securities convertible into common stock, subject to certain exceptions.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the consolidated financial statements and the notes thereto contained elsewhere in this document.

Forward-Looking Statements

We make forward-looking statements in this Quarterly Report on Form 10-Q. These forward-looking statements relate to expectations for future financial performance, business strategies or expectations for our business, and the timing and ability for us to complete future acquisitions. Specifically, forward-looking statements may include statements relating to:

These forward-looking statements are based on information available as of the date hereof, and current expectations, forecasts and assumptions that involve a number of judgments, risks and uncertainties. Accordingly, forward-looking statements should not be relied upon as representing our views as of any subsequent date, and we do not undertake any obligation to update forward-looking statements to reflect events or circumstances after the date they were made, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws. As a result of a number of known and unknown risks and uncertainties, our actual results or performance may be materially different from those expressed or implied by these forward-looking statements. Some factors that could cause our actual results or performance to differ include:

Overview

Inspired Entertainment, Inc. (the "Company," the "Group," "we," "our," and "us") is a global business-to-business gaming technology company, supplying Virtual Sports, Mobile and Server Based Gaming ("SBG") systems to regulated lottery, betting and gaming operators worldwide. We provide end-to-end digital gaming solutions on our proprietary and secure network, which accommodates a wide range of devices, including land-based gaming machine terminals, mobile devices such as smartphones and tablets and online computer and social applications.

Our key strategic priorities are to:

On December 23, 2016, the business combination that created the current Inspired Entertainment, Inc. was consummated (the "Business Combination" or the "Merger"). In connection with the Merger, the Company changed its name from Hydra Industries Acquisition Corp. to Inspired Entertainment, Inc., and changed its fiscal-year end to September 30.

Business Segments

We report our operations in two business segments, Virtual Sports and SBG, representing our different products and services. We evaluate our business performance, resource allocation and capital spending on an operating segment level, where possible. We use our operating results and identified assets of each of our operating segments in order to make prospective operating decisions. Although our revenues and cost of sales (excluding depreciation and amortization) are reported exclusively by segment, we do include unallocated items in our consolidated financial statements for certain expenses including depreciation and amortization as well as selling, general and administrative expenses. Unallocated balance sheet line items include items that are a shared resource and therefore not allocated between operating segments.

Our Virtual Sports business segment designs, develops, markets and distributes ultra-high-definition games that create an always-on sports wagering experience. Our Virtual Sports customers include virtual sports retail and digital operators, including regulated betting operators, lotteries, casinos, online operators and other gaming and lottery operators in the UK, continental Europe, Asia, Africa and North America.

Our SBG business segment designs, develops, markets and distributes a broad portfolio of games through our digital network architecture. Our SBG customers include UK licensed betting offices ("LBOs"), casinos, gaming hall operators, bingo operators and regulated operators of lotteries, as well as government-affiliated operators.

Geographic Range

Geographically, more than half of our revenues are derived from, and more than half of our non-current assets are attributed to, our UK operations, with the remainder of our revenues derived from, and non-current assets attributed to, Italy, Greece and the rest of the world. For the three months ended December 31, 2017, we earned approximately 65.3% of our revenue in the UK, 14.0% in Greece, 13.7% in Italy and the remaining 7.0% across the rest of the world. During the three months ended December 31, 2016, the percentages were 70.8%, 0.0%, 16.2% and 13.0% respectively.

Foreign Exchange

Our results are affected by changes in foreign currency exchange rates as a result of the translation of foreign functional currencies into our reporting currency and the re-measurement of foreign currency transactions and balances. The impact of foreign currency exchange rate fluctuations represents the difference between current rates and prior-period rates applied to current activity. The largest geographic region in which we operate is the United Kingdom, and the British pound ("GBP") is considered to be our functional currency. Our reporting currency is the U.S. dollar ("USD"). Our results are translated from our functional currency of GBP into the reporting currency of USD using average rates for profit and loss transactions and applicable spot rates for period-end balances. The effect of translating our functional currency into our reporting currency, as well as translating the results of foreign subsidiaries that have a different functional currency into our functional currency, is reported separately in Accumulated Other Comprehensive Income.

During the three months ended December 31, 2017, we derived approximately 34.7% of our revenue from sales to customers outside of the UK, compared to 29.2% during the three months ended December 31, 2016.

In the section "Results of Operations" below, currency impacts shown have been calculated as the current-period average GBP: USD rate less the equivalent average rate in the prior period, multiplied by the current period amount in our functional currency (GBP). The remaining difference, referred to as constant currency, is calculated as the difference in our functional currency, multiplied by the prior-period average GBP: USD rate, as a proxy for constant currency movement. This is not a U.S. GAAP measure, but is one which management believes gives a clearer indication of results. In the tables below, variances in particular line items from period to period exclude currency translation movements, and currency translation impacts are shown independently.

Non-GAAP Financial Measures

We use certain financial measures that are not compliant with U.S. GAAP ("non-GAAP financial measures"), including EBITDA and Adjusted EBITDA, to analyze our operating performance. In this discussion and analysis, we present certain non-GAAP financial measures, define and explain these measures and provide reconciliations to the most comparable U.S. GAAP measures. See "-Non-GAAP Financial Measures" later in this Item 2.

Results of Operations

The discussion and analysis of our results of operations have been organized in the following manner: 

The three-month financial periods presented consist of a 92-day period for 2017 and a 98-day period for 2016. The balance sheet date of each fiscal period is December 31. Each of the foregoing periods is herein referred to as a "three-month period."

Our results are affected by changes in foreign currency exchange rates, primarily between our functional currency (GBP) and our reporting currency (USD). In the three-month periods ended December 31, 2017 and 2016, the average USD: GBP rate was 1.34 and 1.25 respectively.

In the tables below, the "Days Movement" column represents values relating to the additional six days in the 2016 quarter as compared to the 2017 quarter. The "Days Movement" column allows for the comparisons shown in the additional "Like-for-Like Variance" columns. For line items in respect of which daily information was available for the additional days in 2016, specific adjustments were made. For line items in respect of which no such information was available, a straight-line method was used to provide pro-rated values. For certain line items, such as Stock-based compensation and Change in fair value of earnout liability, there were no values relating to the additional days in 2016.

In the discussion and analysis below, certain data may vary from the amounts presented in our consolidated financial statements due to rounding.

Three Months ended December 31, 2017 compared to Three Months ended December 31, 2016

Revenue

Total revenue for the quarter ended December 31, 2017 increased by $4.4 million, or 16.1%, from the quarter ended December 31, 2016, to $31.4 million, on a reported basis. Favorable currency movements accounted for $2.3 million of the increase, which was partly offset by a $1.6 million decrease due to there being fewer days in the 2017 period than in the 2016 period. On a like-for-like basis, revenue increased by $3.6 million, or 14.3%.

SBG revenue, which is included in total revenue, above, increased by $2.3 million on a like-for-like basis, or 12.2%, comprised of growth in service revenue of $3.1 million, offset by a reduction in hardware sales of $0.8 million.

SBG service revenue increased by $3.1 million on a like-for-like basis, or 18.4%, as a result of the rollout of terminals in Greece, growth in UK licensed betting office ("LBO") Gross Win per unit per day and a software license sale into the Greek market ("Gross Win per unit per day" is defined as stake less amounts returned to the player in prize, before gaming tax deductions). These increases were partly offset by a change in contract terms for one key UK customer in conjunction with an extension of the end date of the customer's contract without being obligated to make further capital investment.

Hardware revenue decrease was driven by a reduction in SBG terminal sales in the Greek, Electronic Table Games ("ETG") and Colombian markets of $0.6 million, $0.5 million and $0.3 million, respectively. This was offset by an increase in the UK SBBT terminal sales of $0.5 million.

Virtual Sports revenue increased by $1.3 million on a like-for-like basis, or 20.3%, driven by new customer revenue in Greece, Ireland and Poland, as well as an increase in revenue from existing customers, due in part to additional channels offered.

Cost of sales, excluding depreciation and amortization

Cost of sales, excluding depreciation and amortization, which includes machine cost of sales, consumables, content royalties and connectivity costs, increased from the period ended December 31, 2016 by $1.2 million on a reported basis, to $6.1 million. Of this increase, $0.4 million arose from adverse currency movements, offset by a reduction of $0.3 million due to there being fewer days in the current period compared to the comparative period. On a like-for-like basis, cost of sales increased by $1.0 million.

Cost of service increased by $1.3 million on a like-for-like basis due to an increase in Greece SBG service costs of $0.5 million and $0.5 million from additional machine consumable costs on UK SBG terminals. The remaining $0.3 million increase was due to additional third-party royalties payable on new recurring contracts for Virtual Sports.

Cost of hardware decreased by $0.3 million on a like-for-like basis due to lower nil margin hardware sales in Greece and lower hardware sales in the ETG and Colombian markets. This was partly offset by the higher hardware sales in the UK.

Selling, general and administrative expenses

Selling, general, and administrative ("SG&A") expenses include staff compensation costs (including outsourced costs), travel, professional services fees and technology expenses (including hosting fees, data centers and similar charges).

SG&A expenses increased from the 2016 quarterly period to the 2017 quarterly period by $2.6 million, on a reported basis, from $13.7 million to $16.4 million. Of this increase, $1.2 million arose from adverse currency movements, offset by a reduction of $0.8 million due to there being fewer days in the current year period. On a like-for-like basis, SG&A expenses increased by $2.3 million. This increase was driven by additional costs of $1.5 million since the closing of the Business Combination incurred as a result of our public company status and incremental group restructuring costs of $0.7 million.

Stock-based compensation

In connection with the Business Combination, on December 22, 2016, the Company's stockholders approved the Inspired Entertainment, Inc. 2016 Long-Term Incentive Plan (the "2016 Incentive Plan").

As of December 31, 2017, there were 2,778,818 shares authorized for issuance under the 2016 Incentive Plan and 1,086,314 shares not yet subject to outstanding awards. Awards are fair-valued at the time of issuance, with the value being spread over the vesting period. During the current period, 1,076,272 shares previously awarded were converted to derivative liability instruments, making them part of the total number of shares that are now subject to outstanding awards. The Company recorded an expense in the current period of $3.2 million in respect of outstanding awards, of which $2.1 million was as a result of the cancellation of previously granted restricted stock awards and the granting of new restricted stock unit awards now being classified as derivative liabilities and therefore being expensed through stock-based compensation. In addition, there was a charge in the period of $0.3 million relating to employer taxes of vested units. In the prior period, there was a negligible charge for stock-based compensation.

Acquisition related transaction expenses

Acquisition related transaction expenses decreased by $9.9 million in the 2017 quarterly period compared to the 2016 quarterly period, to $0.6 million, on a reported basis. All of the current period expenses related to ongoing work in respect of potential acquisitions. All of the prior period expenses related to the Business Combination.

Depreciation and amortization

Depreciation and amortization increased by $2.4 million in the 2017 quarterly period compared to the 2016 quarterly period, to $9.6 million, on a reported basis. Of this increase, $0.7 million arose from adverse currency movements, partly offset by $0.5 million due to there being fewer days in the 2017 period than the 2016 period.

On a like-for-like, basis, depreciation and amortization increased by $2.2 million. The like-for-like increase was driven by a $2.1 million increase due to additional amortization accruing in connection with new platforms and games going live across SBG and Virtual Sports.

Net Operating loss

On a reported basis, net operating loss decreased from a loss of $9.3 million in the 2016 quarter to a loss of $4.4 million in the 2017 quarter. Of this variance, $0.3 million arose from adverse currency movements. On a like-for-like basis, net operating loss decreased by $5.1 million, mainly due to an increase in revenue and a reduction in transaction expenses.

Interest expense

Interest expense decreased by $9.5 million, or 66%, in the quarter ending December 31, 2017 compared to the comparative period to $4.9 million, on a reported basis. Of this variance, $0.4 million arose from adverse currency movements, offset by $0.9 million due to there being fewer days in the current period. On a like-for-like basis, interest expense decreased by $9.0 million. The decrease was principally due to a $8.9 million reduction in PIK loan note interest and a $0.4 million reduction in debt fee amortization. All PIK loan notes were external to the group prior to the Business Combination on December 23, 2016, at which point they became internal. The PIK loan notes were subsequently waived on May 31, 2017. This reduction was partly offset by a $0.5 million increase in PIK interest charged on our senior debt, as a result of the quarterly compounding of the debt increasing the effective daily charge.

Change in fair value of earnout liability

Change in fair value of earnout liability relates to the potential earnout payment that may be made to the former owners of DMWSL 633 Limited, the amount of which is dependent upon the financial performance of Inspired's businesses in six specific countries (China, Colombia, Greece, Norway, Spain and Ukraine) (collectively, the "Earnout Jurisdictions"), as measured by earnings before interest, taxes, depreciation and amortization for the twelve months ending September 30, 2018 (the "Earnout Period"). As a result of changes in expectations relating to of the Earnout Jurisdictions, and share-price movements, the credit that accrued in the current period resulting from a change in fair value of earnout liability was $4.7 million. In the 2016 period, the corresponding figure was a credit of $1.3 million.

Change in fair value of derivative liability

Change in fair value of derivative liability increased by $0.2 million, to $0.3 million on a reported basis.

Net loss

On a reported basis, net loss improved from a loss of $22.4 million to a loss of $4.2 million. $0.3 million of this variance arose from adverse currency movements. This resulted in a like-for-like improvement of $17.6 million, mainly due to a reduction in transaction expenses, a reduction in interest expense and an increase in revenue.

BUSINESS SEGMENT RESULTS

Server Based Gaming Segment

We generate revenue from our SBG business segment through product sales (both hardware and software) and long-term participation agreements, which include access to our SBG platform and the selection of game titles, usually over a term of, usually three to five years but longer in certain territories. Our participation contracts are typically structured to pay us a percentage of net win (defined as net revenue to our operator customers, after deducting player winnings, free bets or plays and any relevant regulatory levies) from SBG terminals placed in our customers' facilities, which include retail outlets, casinos and other gaming operations, or from SBG gaming software used by customers' players through mobile or online devices. Typically, we recognize revenue from these arrangements on a daily basis over the term of the contract.

Revenue growth for our SBG business is principally driven by the number of operator customers we have, the number of SBG machines in operation, the net win performance of the machines and the net win percentage that we receive pursuant to our contracts with our customers. 

SBG segment, Key Performance Indicators 

(1) Includes all SBG terminals in which the company takes a participation revenue share across all territories

In the table above: 

"End of Period Installed Base" is equal to the number of deployed SBG terminals at the end of each period that have been placed on a participation basis. SBG participation revenue, which comprises the majority of SBG service revenue, is directly related to the terminal installed base. This is the medium by which customers generate revenue and distribute a revenue share to the Company. To the extent all other KPIs remain constant, the larger the installed base, the higher the Company's revenue will be for that period. Management gives careful consideration to this KPI in terms of driving growth across the segment.

Revenues are derived from the performance of the installed base as described by the Gross and Net Win KPIs.

If the End of Period Installed Base is materially different from the Average Installed Base (described below), we believe this gives an indication as to potential future performance. The End of Period Installed Base is particularly useful for assessing new customers or markets, to indicate the progress being made with respect to entering new territories or jurisdictions.  

"Average Installed Base" is the average number of deployed SBG terminals during the period. Therefore, it is more closely aligned to revenue in the period. This measure is particularly useful for assessing existing customers or markets to provide comparisons of historical size and performance. 

Customer Gross Win (defined as stake less amounts returned to player in prize, less free bets or plays, before gaming tax deductions) per unit per day is a KPI used by our internal decision makers to (i) assess impact on the Company's revenue, (ii) determine changes in the strength of the overall market and (iii) evaluate the impacts of regulatory change and our new content releases on our customers. Customer Gross Win per unit per day is the average per unit cash generated across all SBG terminals in which the Company takes a participation revenue share across all territories in the period, defined as the difference between the amounts staked less winnings to players divided by the Average Installed Base in the period, then divided by the number of days in the period.

SBG revenue share income accrued in the period is derived from Customer Gross Win accrued in the period after deducting gaming taxes (defined as a regulatory levy paid by the Customer to government bodies) and applying the Company's contractual revenue share percentage. 

Our internal decision makers believe Customer Gross Win measures are meaningful because they represent a view of customer operating performance that is unaffected by our revenue share percentage and allow management to (1) readily view operating trends, (2) perform analytical comparisons and benchmarking between customers and (3) identify strategies to improve operating performance in the different markets in which we operate.

"Customer Net Win per unit per day" is Customer Gross Win per unit per day after giving effect to the deduction of gaming taxes. 

"Inspired Blended Participation Rate" is the Company's average revenue share percentage across all terminals where revenue is earned on a participation basis, weighted by Customer Net Win per unit per day. 

Our overall SBG revenue from terminals placed on a participation basis can therefore be described as the product of the Average Installed Base, the Customer Net Win per unit per day, the number of days in the period, and the Inspired Blended Participation Rate, to give "participation revenue". 

SBG segment, key events that affected results for the Three Months ended December 31, 2017

Our SBG rollout into the Greek market continued during this period, with approximately 3,500 terminals installed as of December 31, 2017. These represent the majority of the phase 1 rollout plan of 3,960 terminals due to be complete by the first quarter of 2018. We also have a further 2,400 terminals contracted which form part of our phase 2 rollout plan to be delivered across 2018. The performance of our Greek terminals has been very strong compared to other suppliers during the period.

During the period, we launched our new SBG cabinet, the "Flex 4K," with trials in two of our major UK LBO customers and have contracted for the hardware sale with another major UK LBO customer. The "Flex 4K" is our new curved, Ultra HD touchscreen cabinet, offering players a more immersive gaming experience.

In addition to the comparable period in 2016, 223 Self Service Betting Terminals ("SSBTs") were sold and deployed in the UK market. These are expected to provide recurring service revenue in the coming years.

Overall, the size of our Average Installed Base increased 9.5%, to 29,310, due to our continued terminal rollout in Greece. Customer Gross Win per unit per day (in our functional currency, GBP) decreased by 2.6%, also driven by the impact of our SBG installations in Greece, as our Greek machines return a lower daily Customer Gross Win compared to our UK machines. Our blended participation rate has remained consistent at 6.1%.

SBG segment, key events that affected results for the Three Months ended December 31, 2016  

Our UK SBG terminals in LBOs generated Gross Win per unit per day growth on a constant currency basis of 4%, year-over-year.

In the UK market, contract extensions and amendments were signed with two large customers, neither of which required immediate additional capital expenditure. In addition, there was continued SBG rollout into non-LBO UK venues, adding an additional 400 SBG terminals.

In Italy, we released the new titles "White Knight" and "Goddess of the Amazon," which performed well in the estate, and there was continued SBG rollout to a new customer.

SBG segment, Three Months ended December 31, 2017 compared to Three Months ended December 31, 2016

SBG segment revenue. In the period ending December 31, 2017, SBG revenue increased $2.8 million, to $22.8 million, on a reported basis. Of this increase, $1.7 million arose from favorable currency movement, partly offset by $1.1 million due to fewer days in the current period. On a like-for-like basis, SBG revenue increased by $2.3 million, or 12.2%. 

SBG service revenue increased by $3.6 million, or 19.7%, on a reported basis. Of this increase, $1.6 million arose from favorable currency movement, partly offset by $1.1 million due to there being fewer days in the 2017 quarterly period vs than in the 2016 quarterly period. On a like-for-like basis, SBG service revenue increased by $3.1 million, or 18.4%, to $21.8 million, primarily due to the continued rollout of terminals into Greece. This rollout drove additional participation revenue of $1.5 million and other recurring revenue of $0.6 million. In addition, during the 2017 period we completed a software license sale into the Greek market, generating revenue of $1.2 million.

UK LBO Customer Gross Win per unit per day grew by 2.4%. These gains were offset by revised terms agreed in an SBG contract extension with one customer in our UK LBO market. This contract extension nevertheless allowed us to continue to generate revenue without the obligation to make further capital investment. 

SBG hardware revenue decreased by $0.8 million to $1.0 million, on a reported basis, including favorable currency movements of $0.1 million. On a like-for-like basis, SBG hardware revenue decreased by $0.8 million, principally due to higher terminal sales in 2016 in the Greek (these are nil margin sales), ETG and Colombian markets, contributing decreases in the 2017 period of $0.6 million, $0.5 million and $0.3 million, respectively. The decrease was partly offset by a higher volume of UK SBBT hardware sales of $0.5 million. 

SBG segment operating profit.

In the 2017 quarterly period, SBG operating profit decreased by $0.2 million to $6.2 million, on a reported basis. Of this variance, $0.5 million arose from favorable currency movements, offset by a decrease of $0.4 million due to there being fewer days in the 2017 period than in the 2016 period. On a like-for-like basis, SBG operating profit decreased by $0.3 million.

SBG Cost of sales (excluding depreciation and amortization) increased by $0.9 million to $5.0 million, on a reported basis. Of this variance, $0.4 million arose from adverse currency movement, partly offset by $0.2 million due to there being fewer days in the 2017 period than in the 2016 period. On a like-for-like basis, the increase was $0.7 million. This was principally due to an increase in service costs of $1.1 million due to Greek SBG service costs of $0.5 million, and additional machine consumable costs of $0.5 million. This was partly offset by lower hardware costs of $0.3 million due to lower hardware sales.

SBG SG&A expenses increased by $0.1 million to $3.9 million, on a reported basis. Of this variance, $0.3 million arose from adverse currency impact, partly offset by $0.2 million due to there being fewer days in the 2017 period than in the 2016 period. This resulted in a like-for-like increase of $0.1 million.

SBG depreciation and amortization increased by $2.0 million to $7.6 million on a reported basis. Of this amount, $0.5 million arose from adverse currency movement, partially offset by $0.3 million due to there being fewer days in the 2017 period than in the 2016 period. On a like-for-like basis the increase was $1.8 million, driven by a $1.5 million increase in intangible amortization due to new projects going live in the Greek, UK and Italian markets and an increase in machine-related depreciation of $0.5 million driven by the continued terminal rollout in the Greek market. These were partially offset by savings of $0.4 million from fully depreciated terminals in the UK, Italian and Colombian markets.

Virtual Sports Segment

Our Virtual Sports products create a form of simulated sports betting in both a streaming and on-demand environment, overcoming the relative infrequency of live sporting events on which players can wager. We generate revenue from our Virtual Sports segment by licensing to our operator customers the software related to our Virtual Sports products, which consists of a complex graphics and networking software package that provides fixed-odds wagering on an ultra-high definition computer rendering of a virtual sporting event, such as soccer or boxing. Our customers pay us for the use of this software through either a fixed license fee per period, or on a participation basis based on the volume of customer net win. We also generate revenue by providing upfront services to our customers. Revenue growth for our Virtual Sports segment is driven by the number of our customers, the number of player end-points and the customer net win attributable to our products.

Our customers for Virtual Sports include regulated betting operators, lotteries, casinos, online operators and other gaming and lottery operators in the UK, continental Europe, Asia, Africa and North America. Virtual Sports can be adapted to function in a sports betting, lottery, or gaming environment and is therefore available to a wide range of customers in both public and private implementations.

Virtual Sports segment, Key Performance Indicators 

In the table above: 

"No. of Live Customers at the end of the period" and "Average No. of Live Customers" represent the number of customers from which there is Virtual Sports revenue at the end of the period and the average number of customers from which there is Virtual Sports revenue during the period, respectively.

"Total Revenue (£000)" represents total revenue for the Virtual Sports segment, including recurring and upfront service revenue. Total revenue is also divided between "Total Revenue (£000) – Retail," which consists of revenue earned through players wagering at Virtual Sports venues, and "Total Revenue (£000) – Interactive," which consists of revenue earned through players wagering online, including through our mobile remote game server ("Mobile RGS") product.

"Average Revenue per Customer per day" represents total revenue for the Virtual Sports segment in the period, divided by the Average No. of Live Customers, divided by the number of days in the period.

Virtual Sports segment, key events that affected results for the Three Months ended December 31, 2017 

As of December 31, 2017, OPAP offered our Virtual Sports product in over 4,000 retail venues following launch in April 2017.

During the 2017 quarterly period, our Virtual Sports products continued to grow in Poland through the retail venues and online channels of Fortuna, Central Europe's largest betting operator. Under an agreement that extends to 2019, Fortuna customers in Poland are able to play Virtual Football (soccer), Virtual Horses, Virtual Greyhounds, Virtual Speedway and Virtual Motor Racing. 

By the end of the 2017 quarterly period, our Mobile RGS business was live with sixteen customers, having launched ten new customers since December 31, 2016, including Betfair, Grosvenor Casino (part of the Rank Group), Bwin, Sportingbet, VideoSlots, and a variety of Betsson brands. The Average Number of Live Customers increased by nine, from 74 to 83, including new RGS customers. Average Revenue per Customer per day for the year increased by £54, or 6.9%, from £781 to £834.

Virtual Sports segment, key events that affected results for the Three Months ended December 31, 2016

We had successful go-lives with two new Mobile RGS integrations, our fifth and sixth customers, respectively, in the Mobile RGS space. "Rush Football 2" went live with two of our Italian customers, enhancing revenue in the Italian Virtual Sports retail and online markets. Further game integrations were also completed during the three-month period further increasing our revenues from all Mobile RGS customers.

Virtual Sports segment, Three Months ended December 31, 2017 compared to Three Months ended December 31, 2016

Virtual Sports segment revenue. During the 2017 quarterly period, Virtual Sports revenue increased $1.5 million compared to the 2016 quarterly period, on a reported basis. Of this increase, $0.6 million arose from favorable currency movements, partly offset by $0.4 million due to there being fewer days in the 2017 period than the 2016 period. On a like-for-like basis, Virtual Sports revenue increased by $1.3 million, or 20.3%, to $8.6 million.

This increase was principally the result of recurring revenue growth of $1.4 million in Virtual Sports land-based and online customers, due to the addition of Greece's OPAP as a new customer as well as new customers in Ireland and Poland. A $0.5 million increase arose from further RGS penetration into the mobile market, where the number of our customers increased from six to sixteen. These increases were partly offset by a $0.5 million reduction in revenue from long term licenses that have now come to an end.

Virtual Sports segment operating profit.

In the 2017 quarterly period, Virtual Sports operating profit increased by $0.5 million, or 15.4%, on a reported basis. Of this increase, $0.3 million arose from favorable currency movements, partly offset by $0.2 million due to there being fewer days in the 2017 period than the 2016 period. On a like-for-like basis, this represented an increase of $0.4 million, or 13.5%.

Virtual Sports Cost of service increased by $0.3 million to $1.1 million, on a reported basis. Of this increase, $0.1 million arose from adverse currency movement, offset by $0.1 million due to there being fewer days in the 2017 period than the 2016 period. On a like-for-like basis, cost of service increased by $0.3 million, due to additional third-party royalties payable on new recurring contracts.

Virtual Sports SG&A expenses increased by $0.1 million, on a reported basis. Of this increase, $0.1 million arose from adverse currency movement, offset by $0.1 million due to there being fewer days in the 2017 period than the 2016 period. This resulted in a like-for-like increase of $0.1 million.

Virtual Sports Depreciation and amortization increased by $0.5 million to $1.6 million, on a reported basis. Of this increase, $0.1 million arose from adverse currency movement, offset by $0.1 million due to there being fewer days in the 2017 period than the 2016 period. This resulted in a like-for-like increase of $0.5 million, due to additional deprecation of platforms and games going live.

Non-GAAP Financial Measures

We use certain non-GAAP financial measures, including EBITDA and Adjusted EBITDA, to analyze our operating performance. We use these financial measures to manage our business on a day-to-day basis. We believe that these measures are also commonly used in our industry to measure performance. For these reasons, we believe that these non-GAAP financial measures provide expanded insight into our business, in addition to standard U.S. GAAP financial measures. There are no specific rules or regulations for defining and using non-GAAP financial measures, and as a result the measures we use may not be comparable to measures used by other companies, even if they have similar labels. The presentation of non-GAAP financial information should not be considered in isolation from, or as a substitute for, or superior to, financial information prepared and presented in accordance with U.S. GAAP. You should consider our non-GAAP financial measures in conjunction with our U.S. GAAP financial measures.