Hydra Industries Acquisition Corp. (HDRAU) SEC Quarterly Report (10-Q) for Q1 2018

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2018

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 May 8, 2018, there were 21,484,707 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 INCOME (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

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Company Description and Nature of Operations

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.

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 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 March 31, 2018, the Company's cash on hand was $13,419 and the Company had a working capital deficit of $20,944. As of March 31, 2018, $6,355 of our $13,419 of cash on hand had arisen in Greece and was being held there in our Greek accounts. In the ordinary course of business, we seek, from time to time, to transfer funds earned in Greece to our accounts outside of Greece. However, Greece imposes capital controls that complicate, and can delay or prevent, the flow of capital out of that country. The Company recorded net losses of $4,653 and $31,503 for the six months ended March 31, 2018 and 2017, 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, annually 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 $20,944 includes non-cash settled items of $8,317 for the earnout liability and $9,671 of deferred income. 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 May 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 and six months ended March 31, 2018 are not necessarily indicative of the results to be expected for the year ending September 30, 2018 or for any future interim periods.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

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 six-month period ended March 31, 2017 includes the results of operations for the Company for the period from September 25, 2016 through March 31, 2017. 

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, the British pound (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 selling, general and administrative expenses and interest income (expense) in the condensed consolidated statements of operations and comprehensive loss.

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, 2018. 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. 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. 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).

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Accounts receivable consist of the following:

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 $503 and $419 as of March 31, 2018 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:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Depreciation and amortization expense amounted to $5,266 and $4,519 for the three months ended March 31, 2018 and 2017, respectively, and $10,058 and $9,157 for the six months ended March 31, 2018 and 2017, respectively.

Software development costs, net consisted of the following:

During the three and six months ended March 31, 2018, the Company capitalized $4,337 and $8,680 of software development costs, respectively. Amounts in the above table include $1,487 and $2,676 of internal use software at March 31, 2018 and September 30, 2017, respectively.

The total amount of software costs amortized was $4,635 and $2,444 for the three months ended March 31, 2018 and 2017, respectively, and $8,561 and $4,193 for the six months ended March 31, 2018 and 2017, respectively. Software costs written down to net realizable value amounted to $342 for the three and six months ended March 31, 2018 and $263 for the three and six months ended March 31, 2017. The weighted average amortization period was 3.2 years for the three and six months ended March 31, 2018.

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.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Aggregate intangible asset amortization expense amounted to $877 and $777 for the three months ended March 31, 2018 and 2017, respectively, and $1,719 and $1,558 for the six months ended March 31, 2018 and 2017, 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 March 31, 2018 and September 30, 2017 (amounting to $2,149), as reported in the accompanying unaudited interim condensed consolidated balance sheets, is attributable to foreign currency translation adjustments.

Accrued expenses consist of the following:

Other liabilities consist of the following:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

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 financial 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:

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:

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

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 principal financial officer, who reports to the principal 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 principal financial officer and approved by the principal 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 March 31, 2018 and September 30, 2017, there were no transfers in or out of Level 3 from other levels in the fair value hierarchy.

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 Gaming Group (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 ($21,017), the Selling Group will receive an aggregate of 2,500,000 shares of common stock. If such EBITDA is less than £15,000 ($21,017), 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 ($21,017).

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 $8,317 and $16,728 at March 31, 2018 and September 30, 2017, respectively. 

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

The key assumptions in applying the Monte Carlo simulation include the Company's stock price, the Earnout Period EBITDA in the Earnout Jurisdictions for the period ending September 30, 2018, a risk-adjusted discount rate of 13.5% as of March 31, 2018, a standard deviation of 48.4% as of March 31, 2018 (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 (a maximum of 2,500,000 shares). 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):

The Company's Second Long-Term Incentive Plan (the "Second Incentive Plan") was adopted by the Company's Board of Directors in December 2016 subject to approval by the Company's stockholders, which was obtained in March 2018. Awards granted under the Second Incentive Plan prior to approval by stockholders were classified as a derivative liability due to the Company's obligation to settle such awards in cash in the event stockholders did not approve the plan. Such obligation was eliminated upon stockholder approval being obtained, which resulted in the liability being reclassified to additional paid in capital at the fair value amount of $2,848.

The Company's stock-based compensation plans authorize awards of restricted stock units, stock options and other equity awards. As of March 31, 2018, there were 2,289,881 shares subject to outstanding awards and 1,226,606 shares remaining available for future awards.

On January 2, 2018, the Company granted 27,000 RSUs under the 2016 Incentive Plan to members of the Company's Board of Directors. One-quarter of the RSUs vested on the date of grant, with the remaining RSUs vesting quarterly on April 1, 2018, July 1, 2018 and October 1, 2018. The weighted average fair value of the awards on the date of grant was $9.70 per share. The grant date fair value of the awards is being recognized as compensation expense over the vesting period. The aggregate grant date fair value of the RSUs amounted to $262, of which the Company recorded $83 as compensation expense during the period ended March 31, 2018.

Stock-based compensation is recognized as an expense on a straight-line basis over the requisite service period, which is generally the vesting period. The modification of certain awards held by two executive officers of the Company in December 2017 resulted in $2,105 of incremental compensation cost being recognized as of the modification date.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

The company recognized stock-based compensation expense as follows:

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

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 the Company until the fiscal year beginning October 1, 2018. Nonetheless, the Company continues to evaluate the impact of the Act on the tax provision.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

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 March 31, 2018 and 2017 was (20.0%) and (0.4%), respectively, resulting in an $83 and $32 income tax expense, respectively. The effective income tax rate for the six months ended March 31, 2018 and 2017 was (2.6%) and (0.3%), respectively, resulting in a $116 and $83 income tax expense, respectively. The income tax expense for the three and six months ended March 31, 2018 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 and six months ended March 31, 2017 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 $50,830 as of March 31, 2018.

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.

We incurred certain offering expenses in connection with an underwritten public offering of shares principally held by our largest stockholder, Landgame S.à.r.l, which closed in January 2018 as to which our expenses were reimbursed by the selling stockholders. For the three and six months ended March 31, 2018, the aggregate amount invoiced for reimbursement was $479 and $650, respectively.

We paid consulting fees to an entity owned by Jim O'Halleran, who was a director of Inspired prior to the Business Combination. For the three and six months ended March 31, 2017, the fees totaled $196 and $294, respectively. The agreement terminated in November 2017.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

An affiliate of Landgame S.à.r.l has had an ownership interest in one of our customers. For the three and six months ended March 31, 2017, we received contract revenues totaling $365 and $797, respectively. We also had an accounts receivable balance with respect to such customer in the amount of $633 as of September 30, 2017, which was no longer outstanding as of March 31, 2018.

Legal Matters

From time to time, the Company may become involved in lawsuits and legal matters arising in the ordinary course of business. While the Company believes that, currently, it has no such matters that are material, there can be no assurance that existing or new matters arising in the ordinary course of business will not have a material adverse effect on the Company's business, financial condition or results of operations.

As previously disclosed, 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, seeking damages as a result of his services not continuing beyond the Business Combination. In March 2018, this matter was settled by the parties.

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 $3,388 will be contributed to the pension plan during the year ending September 30, 2018.

The total amount of employer contributions paid during the six months ended March 31, 2018 amounted to $1,775. We expect to contribute $1,613 during the remaining part of the fiscal period.

For the six months ended March 31, 2018 and 2017, the components of total periodic benefit costs were as follows:

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 and six months ended March 31, 2018, 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.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Segment Information

Three Months Ended March 31, 2018

Three Months Ended March 31, 2017

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

Six Months Ended March 31, 2018

Six Months Ended March 31, 2017

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(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 March 31, 2018, three customers represented at least 10% of revenues, accounting for 23%, 19% and 15% of the Company's revenues. During the three months ended March 31, 2017, two customers represented at least 10% of revenues, accounting for 27% and 13% of the Company's revenues. All these customers were served by both the Server Based Gaming and Virtual Sports segments. 

During the six months ended March 31, 2018, three customers represented at least 10% of revenues, accounting for 25%, 15% and 14% of the Company's revenues. During the six months ended March 31, 2017, two customers represented at least 10% of revenues, accounting for 29% and 12% of the Company's revenues. All these customers were served by both the Server Based Gaming and Virtual Sports segments. 

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2018

(in thousands, except share and per share data)

(Unaudited)

At March 31, 2018, two customers represented at least 10% of accounts receivable, accounting for 16% 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.

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 May 2, 2018, the Company announced that it has formed the Office of Executive Chairman, which consists of Executive Chairman A. Lorne Weil; President and Chief Operating Officer Brooks H. Pierce; Executive Vice President and Chief Strategy Officer Daniel B. Silvers and Executive Vice President and Chief Financial Officer Stewart F.B. Baker. The Office of the Executive Chairman will execute the day-today management of the Company.

In connection with the formation of the Office of Executive Chairman, on May 1, 2018 Mr. Pierce was appointed President and Chief Operating Officer of the Company and Mr. Baker, the Company's Chief Financial Officer, was appointed to the new position of Executive Vice President and Chief Financial Officer. Mr. Pierce, 56, has over 25 years of experience in the gaming industry. He joined the Company as Senior Vice President, North America, earlier this year. Prior to joining the Company, Mr. Pierce held the position of Chief Executive Officer of BHP Consulting Group, LLC ("BHP"), a sales, marketing and leadership consulting firm that provided consulting services to the Company from May 2017 through March 2018, during which time BHP received $10,000 per month in fees as well as reimbursement of certain expenses. The Company and Mr. Pierce have entered into an employment agreement setting forth the terms and conditions of Mr. Pierce's employment, including an annual base salary of $400,000; an annual bonus opportunity of from 100% (target) to 200% (maximum) of his base salary, subject to the Company meeting specified performance targets and he himself meeting specified individual performance targets. In addition, Mr. Pierce has been awarded 100,000 restricted stock units under the Company's Second Incentive Plan.

On May 2, 2018, the Company also announced that Luke L. Alvarez, President and Chief Executive Officer, was departing the Company and its affiliates, under terms being finalized. Mr. Alvarez's previous responsibilities will be divided among the members of the Office of Executive Chairman.

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 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 March 31, 2018, we earned approximately 65.8% of our revenue in the UK, 14.6% in Greece, 12.5% in Italy and the remaining 7.1% across the rest of the world. During the three months ended March 31, 2017, the percentages were 71.0%, 2.7%, 14.5% and 11.8%, respectively. For the six months ended March 31, 2018, we earned approximately 65.6% of our revenue in the UK, 14.3% in Greece, 13.1% in Italy and the remaining 7.1% across the rest of the world. During the six months ended March 31, 2017, the percentages were 70.8%, 2.4%, 15.3% and 11.5%, 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 March 31, 2018, we derived approximately 34.2% of our revenue from sales to customers outside of the UK, compared to 29.0% during the three months ended March 31, 2017. During the six months ended March 31, 2018, we derived approximately 34.4% of our revenue from sales to customers outside of the UK compared to 29.1% during the six months ended March 31, 2017.

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 90-day period for 2018 and 2017. The balance sheet date of each fiscal period is March 31. Each of the foregoing periods is herein referred to as a "three-month period."

The six-month financial periods presented consist of a 182-day period for 2018 and a 188-day period for 2017. The balance sheet date of each fiscal period is March 31. Each of the foregoing periods is herein referred to as a "six-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 March 31, 2018 and 2017, the average USD: GBP rate was 1.40 and 1.24, respectively. In the six-month periods ended March 31, 2018 and 2017, the average USD: GBP rate was 1.37 and 1.24, respectively.

In the tables below, the "Days Movement" column represents values relating to the additional six days in the 2017 "six-month period" as compared to the 2018 "six-month period". The "Days Movement" column allows for the comparisons shown in the additional "Like-for-Like Variance" columns. Such columns are not presented for the three months periods, as such periods in both years were 90 days. For line items in respect of which daily information was available for the additional days in 2017, 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 2017.

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

Results of Operations –

Three Months ended March 31, 2018 compared to Three Months ended March 31, 2017

Revenue

Total revenue for the quarter ended March 31, 2018 increased by $9.4 million, or 33.5%, from the quarter ended March 31, 2017, to $37.5 million, on a reported basis. Favorable currency movements accounted for $4.3 million of the increase, meaning constant currency revenue increased by $5.1 million, or 18.2%.

SBG revenue, which is included in total revenue, above, increased by $5.0 million on a constant currency basis, or 25.5%, comprised of growth in service revenue of $3.9 million and in hardware sales of $1.1 million.

SBG service revenue increased by $3.9 million on a constant currency basis, or 23.2%, as a result of the continued rollout of terminals in Greece driving a $2.8 million increase and software license sales of $1.1 million into the Greek market.

Hardware revenue increase was driven by terminal sales of our new "Flex 4K" product of $3.2 million, offset by lower hardware sales in the UK (excluding the "Flex 4K" product), Greek, Colombian and the Electronic Table Gaming ("ETG") markets of $1.2 million, $0.6 million, $0.3 million and $0.1 million, respectively.

Virtual Sports revenue increased by $0.1 million on a constant currency basis, or 1.0%, driven by new customer revenue from our mobile remote game server ("Mobile RGS") product, continued growth in Greece and Poland and a new customer in Finland. Growth was negatively affected by a timing difference in the 2018 contract renewal of a major customer and by the recognition of 2017 revenues previously unreported to us, as well as by the timing of RGS content sales. Excluding these, Virtual Sports revenue increased by $1.6 million on a constant currency basis, or 24%.

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 March 31, 2017 by $4.4 million, or 77.4%, on a reported basis, to $10.1 million. Of this increase, $1.2 million arose from adverse currency movements. On a constant currency basis, cost of sales increased by $3.3 million, or 57.2%.

Cost of service increased by $2.1 million, or 64.8%, on a constant currency basis due to an increase in Greece SBG service costs of $1.0 million and $0.3 million from additional costs to service UK SBG terminals. $0.5 million of the increase was due to the additional cost of supporting new recurring contracts for Virtual Sports.

Cost of hardware increased by $1.2 million, or 47.2%, on a constant currency basis due to incremental hardware sales in the UK. Hardware sales are made at nil margin in certain circumstances to secure long-term revenue share contracts.

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 by $1.2 million, or 8.5%, on a reported basis, to $15.6 million. Of this increase, $1.8 million arose from adverse currency movements. On a constant currency basis, SG&A expenses decreased by $0.6 million, or 4.0%, due to staff related cost savings.

Stock-based compensation

We have two stock-based compensation plans pursuant to which we issue awards of restricted stock units, stock options and other equity awards: the 2016 Long-Term Incentive Plan, which was approved by stockholders in December 2016 (the "First Incentive Plan"), and the Second Long-Term Incentive Plan, which was approved by stockholders in March 2018 (the "Second Incentive Plan").

The aggregate number of shares authorized for issuance under these plans is 4,078,818 and, as of March 31, 2018, there were 2,289,881 shares subject to outstanding awards. 562,331 shares have been awarded and issued as of March 31, 2018. Awards are fair-valued at the time of issuance, with the value being spread over the vesting period. During the 2018 period, the Company recorded an expense of $1.3 million in respect of outstanding awards, which was in line with the prior year charge for stock-based compensation.

Acquisition related transaction expenses

Acquisition related transaction expenses decreased by $0.6 million in the period, to $0.2 million, on a reported basis. All of the 2018 period expenses were related to work in respect of potential acquisitions. All of the prior period expenses were related to the Business Combination.

Depreciation and amortization

Depreciation and amortization increased by $3.1 million or 38.9%, to $11.1 million, on a reported basis. Of this increase, $1.3 million arose from adverse currency movements.

On a constant currency basis, depreciation and amortization increased by $1.8 million, or 23.0%. The constant currency increase was driven by a $1.7 million increase due to additional amortization accruing in connection with new platforms and games going live across SBG ($1.6 million) and Virtual Sports ($0.1 million).

Net operating loss

On a reported basis, net operating loss improved from a loss of $2.1 million in the 2017 period to a loss of $0.9 million in the 2018 period, of which $0.1 million arose from adverse currency movements. On a constant currency basis, net operating loss decreased by $1.4 million, due to an increase in revenue and a decrease in acquisition related expenses and SG&A. This was partly offset by an increase in cost of sales and depreciation and amortization.

Interest expense

Interest expense increased by $0.6 million, or 13.6%, in the quarter ended March 31, 2018, to $5.2 million, on a reported basis. This variance arose from adverse currency movements. On a constant currency basis, interest expense remained consistent with the quarter ended March 31, 2017. There were higher cash and PIK charges on the existing senior debt due to continued compounding of the PIK interest charge of $0.7 million and a small $0.1 million increase in the level of revolver interest paid. This was offset due to no amortization of debt fees in the current year. These fees had been fully amortized by the end of September 2017.

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 ($5.50 at March 31, 2018 and $9.80 at December 31, 2017), the credit that accrued in the current quarter resulting from a change in fair value of earnout liability was $3.8 million. In the corresponding quarter in the prior year, the corresponding figure was a charge of $2.2 million.

Change in fair value of derivative liability

Change in fair value of derivative liability decreased by $1.8 million, to a $1.6 million credit on a reported basis. This was predominantly due to the reduction in share price.

Net loss

On a reported basis, net loss improved from a loss of $9.1 million to a loss of $0.5 million. This resulted from the change in fair value liabilities and an increase in revenue, partly offset by $0.1 million from adverse currency movements and an increase in cost of sales and depreciation and amortization.

Results of Operations –

Three Months ended March 31, 2018 compared to Three Months ended March 31, 2017 –

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 March 31, 2018

Our SBG rollout into the Greek market continued, with approximately 3,900 terminals installed as of March 31, 2018. During the period a further 1,035 terminals were contracted, which form part of our phase two rollout plan to be delivered across 2018. The performance of our Greek terminals continues to be strong compared to other suppliers during the period.

During the period, we supplied over 500 of our "Flex 4K" products to our second largest UK LBO customer. The "Flex 4K" product is our new curved, Ultra HD touchscreen cabinet, offering players a more immersive gaming experience. We also deployed a further 600 of our "Eclipse" terminals with the same UK customer, resulting in a total machine growth of 23% with this customer.

Another of our major UK LBO customers was contracted for a further three years during the period. The contract extension includes the deployment of an additional 112 "Eclipse" terminals during April and May 2018, further increasing our UK LBO estate.

Overall, the size of our Average Installed Base increased 13.7%, to 30,723, due to our continued terminal rollout in Greece and contract awards in the UK LBO estate. Customer Gross Win per unit per day (in our functional currency, GBP) decreased by 3.7%, 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 increased 0.2% to 6.1%.

Despite the overall reduction in Customer Gross Win per unit per day, the Italian market increased by 13.0% on this measure due to new content releases and improved account management. Our UK SBG terminals in LBOs also generated year-over-year growth of 2.2% in Gross Win per unit per day on a constant currency basis.

SBG segment, Three Months ended March 31, 2018 compared to Three Months ended March 31, 2017

SBG segment revenue. In the period ended March 31, 2018, SBG revenue increased $8.2 million, to $27.8 million, on a reported basis. Of this increase, $3.2 million arose from favorable currency movements. On a constant currency basis, SBG revenue increased by $5.0 million, or 25.5%.

SBG service revenue increased by $6.6 million, or 39.2%, on a reported basis. Of this increase, $2.7 million arose from favorable currency movements. On a constant currency basis, SBG service revenue increased by $3.9 million, or 23.2%, to $23.6 million, primarily due to the continued rollout of terminals into Greece. This rollout drove additional participation revenue of $1.9 million and other recurring revenue of $0.7 million. In addition, during the quarter we completed a software license sale into the Greek market, generating revenue of $1.1 million. SBG service revenue increased on a constant currency basis in the Greek, UK Other (includes UK casinos, gaming hall operators and bingo operators) and Italian markets by $3.8 million, $0.2 million and $0.1 million, respectively, due to the continued rollout in Greece and growth in Italy.

UK LBO Customer Gross Win per unit per day grew by 2.2%. The gains from this increase were offset by revised terms in an SBG contract renewal with one customer in our UK LBO market which was renewed without requiring further capital expenditure.

SBG hardware revenue increased by $1.6 million to $4.2 million, on a reported basis, including favorable currency movements of $0.5 million. On a constant currency basis, SBG hardware revenue increased by $1.1 million, principally due to terminal sales of our new "Flex 4K" product (these are nil margin sales) of $3.2 million, offset by lower hardware sales in the UK (excluding the "Flex 4K" product) of $1.2 million and lower hardware sales in Greece, Colombia and the ETG markets of $0.6 million, $0.3 million and $0.1 million, respectively.

SBG segment operating profit. In the 2018 period, SBG operating profit increased by $1.5 million to $6.2 million, on a reported basis, $0.7 million of which arose from favorable currency movements. On a constant currency basis, SBG operating profit increased by $0.8 million.

SBG cost of sales (excluding depreciation and amortization) increased by $3.7 million to $8.8 million, on a reported basis, $1.0 million of which arose from adverse currency movements. On a constant currency basis, cost of sales increased by $2.7 million. This was principally due to an increase in service costs of $1.6 million, due to Greek SBG service costs of $1.0 million and additional machine consumable costs of $0.3 million, and an increase in hardware costs of $1.2 million due to higher hardware sales in the UK market.

SBG SG&A expenses increased by $0.2 million to $4.0 million, on a reported basis. $0.5 million arose from adverse currency movements, which resulted in a constant currency decrease of $0.3 million.

SBG depreciation and amortization increased by $2.8 million to $8.7 million on a reported basis. Of this amount, $1.0 million arose from adverse currency movements. On a constant currency basis, the increase was $1.8 million, driven by a $1.6 million increase in intangible amortization due to new projects going live in the Greek and UK markets. There was also an increase in machine-related depreciation of $0.8 million driven by the continued terminal rollout in the Greek and UK markets. These were partially offset by savings of $0.6 million from fully depreciated terminals in the Italian market and the sale of assets in the Colombian market.

SBG segment, Service Revenue by Region

Set forth below is a breakdown of our SBG service revenue by geographic region. SBG service revenue consists principally of SBG participation revenue.