Hydra Industries Acquisition Corp. (HDRAU) SEC Quarterly Report (10-Q) for Q2 2018

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 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 August 13, 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

JUNE 30, 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 June 30, 2018, the Company's cash on hand was $10,176 and the Company had a working capital deficit of $7,667. As of June 30, 2018, $2,593 of our cash on hand had arisen in Greece and was being held 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 $8,672 and $39,834 for the nine months ended June 30, 2018 and 2017, respectively. The net losses arose principally due to 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 $7,667 includes non-cash settled items of $8,961 for the earnout liability and $11,021 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 amounts available from the Company's external borrowings will be sufficient to fund the Company's net cash requirements through August 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.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

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 nine months ended June 30, 2018 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 nine-month period ended June 30, 2017 includes the results of operations for the Company for the period from September 25, 2016 through June 30, 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, 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

JUNE 30, 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 $460 and $419 as of June 30, 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

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

Depreciation and amortization expense amounted to $5,398 and $4,669 for the three months ended June 30, 2018 and 2017, respectively, and $15,456 and $13,827 for the nine months ended June 30, 2018 and 2017, respectively.

Software development costs, net consisted of the following:

During the three and nine months ended June 30, 2018, the Company capitalized $4,447 and $13,127 of software development costs, respectively. Amounts in the above table include $1,352 and $2,676 of internal use software at June 30, 2018 and September 30, 2017, respectively.

The total amount of software costs amortized was $4,366 and $3,232 for the three months ended June 30, 2018 and 2017, respectively, and $12,927 and $7,425 for the nine months ended June 30, 2018 and 2017, respectively. Software costs written down to net realizable value amounted to $0 and $342 for the three and nine months ended June 30, 2018, respectively, and $0 and $263 for the three and nine months ended June 30, 2017, respectively. The weighted average amortization period was 3.2 years for the three and nine months ended June 30, 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

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

Aggregate intangible asset amortization expense amounted to $853 and $804 for the three months ended June 30, 2018 and 2017, respectively, and $2,572 and $2,362 for the nine months ended June 30, 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 June 30, 2018 and September 30, 2017 (amounting to $689), 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

JUNE 30, 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

JUNE 30, 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 June 30, 2018 and September 30, 2017, there were no transfers in or out of Level 3 from other levels in the fair value hierarchy.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

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 ($19,805), the Selling Group will receive an aggregate of 2,500,000 shares of common stock. If such EBITDA is less than £15,000 ($19,805), 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 ($19,805).

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 $8,961 and $16,728 at June 30, 2018 and September 30, 2017, respectively. 

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 13.7% as of June 30, a standard deviation of 44.7% as of June 30, 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.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

The Company's stock-based compensation plans authorize awards of restricted stock units, stock options and other equity awards. As of June 30, 2018, there were 2,383,280 shares subject to outstanding awards and 1,133,207 shares remaining available for future awards.

On January 2, 2018, the Company granted 27,000 RSUs under its 2016 Long-Term Incentive Plan (the "First 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 $71 and $154 as compensation expense during the three and nine months ended June 30, 2018, respectively.

On May 1, 2018, the Company granted 100,000 RSUs under the Second Incentive Plan to a member of the Company's executive team, which will vest on May 1, 2020. The weighted average fair value of the award on the date of grant was $4.95 per share. The grant date fair value of the award is being recognized as compensation expense over the vesting period. The aggregate grant date fair value of the RSUs amounted to $495, of which the Company recorded $41 as compensation expense during the three and nine months ended June 30, 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.

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.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

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.

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 June 30, 2018 and 2017 was (1.0%) and 1.0%, respectively, resulting in a ($39) and $86 income tax (expense)/benefit, respectively. The effective income tax rate for the nine months ended June 30, 2018 and 2017 was (1.8%) and 0.0%, respectively, resulting in a ($155) and $3 income tax (expense)/benefit, respectively. The income tax expense for the three and nine months ended June 30, 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 nine months ended June 30, 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 $51,575 as of June 30, 2018.

The utilization of the Company's pre-Merger net operating losses are subject to a limitation due to the "change of ownership provisions" under Section 382 of the Internal Revenue Code and similar state provisions.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

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 nine months ended June 30, 2018, the aggregate amount invoiced for reimbursement was $20 and $670, 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 nine months ended June 30, 2017, the fees totaled $11 and $304, respectively. The agreement terminated in November 2017.

An affiliate of Landgame S.à.r.l has had an ownership interest in one of our customers. For the three and nine months ended June 30, 2017, we received contract revenues totaling $404 and $1,201, 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 June 30, 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.

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 $3,318 will be contributed to the pension plan during the year ending September 30, 2018.

The total amount of employer contributions paid during the nine months ended June 30, 2018 amounted to $2,559. We expect to contribute $759 during the remaining part of the fiscal period.

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

For the nine months ended June 30, 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 nine months ended June 30, 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.

Segment Information

Three Months Ended June 30, 2018

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

Three Months Ended June 30, 2017

Nine Months Ended June 30, 2018

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

Nine Months Ended June 30, 2017

Geographic Information

Geographic information for revenue is set forth below:

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

INSPIRED ENTERTAINMENT, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2018

(in thousands, except share and per share data)

(Unaudited)

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

During the three months ended June 30, 2018, three customers represented at least 10% of revenues, accounting for 23%, 21% and 11% of the Company's revenues. During the three months ended June 30, 2017, two customers represented at least 10% of revenues, accounting for 25% and 10% of the Company's revenues. All these customers were served by both the Server Based Gaming and Virtual Sports segments. 

During the nine months ended June 30, 2018, three customers represented at least 10% of revenues, accounting for 24%, 17% and 14% of the Company's revenues. During the nine months ended June 30, 2017, two customers represented at least 10% of revenues, accounting for 27% and 11% of the Company's revenues. All these customers were served by both the Server Based Gaming and Virtual Sports segments. 

At June 30, 2018, two customers represented at least 10% of accounts receivable, accounting for 31% and 14% 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. 

Refinancing of External Borrowings

After the quarter end, the Company and certain of its subsidiaries entered into a series of transactions that effected the refinancing of the group's external borrowings, replacing the group's senior term and revolving facilities, originally entered into in 2014, with senior notes of $140.0 million and a revolving credit facility of £7.5 million (equivalent to approximately $9.9 million). As described in further detail below, the senior notes have a 5-year duration and carry a cash interest rate of 9% plus 3-month LIBOR, and the revolving credit facility has a 3-year duration and carries a cash interest rate on any utilization at 4% plus 3-month LIBOR, with any unutilized amount carrying a 1.4% cash interest cost. In connection with the refinancing, the Company also entered into a three-year, fixed-rate, cross-currency swap, as described in further detail below.

Note Purchase Transaction

On August 13, 2018, Gaming Acquisitions Limited ("Gaming Acquisitions"), an indirect wholly owned subsidiary of the Company, certain subsidiaries of the Company (collectively, the "Subsidiary Guarantors" and together with Gaming Acquisitions and the Company, the "Credit Parties") and the Company entered into a Note Purchase Agreement and Guaranty (the "Note Purchase Agreement") to provide for the issuance and sale of promissory notes in the aggregate principal amount of $140,000,000, maturing in five years (the "Notes"), to the purchasers party thereto from time to time, including HG Vora Special Opportunities Master Fund, Ltd. ("HGV Fund"), with Cortland Capital Market Services LLC acting as note and collateral agent for the Purchasers (in such capacity, "Agent").

The proceeds of the sale of the Notes will be used to, among other things, repay £98.5 million of obligations outstanding under the Company's Senior Term and Revolving Facility Agreement dated March 18, 2014 (as amended and restated July 13, 2016), among certain subsidiaries of the Company, Ares Management Limited and Lloyds Bank PLC (the "Existing Credit Facility"). The Existing Credit Facility has been replaced in part by the Revolving Credit Facility described below.

The obligations under the Note Purchase Agreement are unconditionally guaranteed on a joint and several basis by each of the Company and the Subsidiary Guarantors party thereto and are secured on a first-priority basis (subject to certain exceptions) by a lien granted to the Agent for the benefit of the secured parties under the Note Purchase Agreement on substantially all of the assets of each Credit Party, including all of the capital stock held by such Credit Party. An intercreditor agreement will set forth the rights and obligations of the parties to the Note Purchase Agreement, the Revolving Credit Facility and the Nomura Swap described below, in and to the proceeds of the collateral securing the obligations under the Note Purchase Agreement, the Revolving Credit Facility and the Nomura Swap.

The Notes will be issued at 98% of the par value thereof. Interest on the Notes shall accrue on a daily basis and will bear an interest rate equal to, at the Credit Parties' option, a base rate or LIBOR rate, plus an applicable margin, which for a base rate borrowing is 8% per annum and for a LIBOR borrowing is 9% per annum. The base rate is calculated based on the greatest of the prime rate, federal funds effective rate and LIBOR rate in effect on the date of calculation. Interest on the Notes is payable in cash (subject to extension in the case of the first interest payment due thereunder as provided in the Note Purchase Agreement) and at the maturity of the Notes in the case of any unpaid interest then outstanding.

Subject to certain conditions, voluntary prepayments are permitted under the Note Purchase Agreement.

Subject to certain exceptions, Gaming Acquisitions is required to make mandatory prepayments of the Notes in respect of amounts received on account of asset sales, insurance or condemnation proceeds and issuances of debt as well as amounts constituting excess cash flows. In the case of proceeds from asset sales and insurance or condemnation payments, so long as no event of default has occurred and to the extent such proceeds do not exceed $1,000,000, Gaming Acquisitions may invest such proceeds-directly or through one of its subsidiaries-in assets of the general type useful in the business of the Company and its subsidiaries. In the case of amounts constituting excess cash flow, Gaming Acquisitions is required to prepay an amount equal to 50% thereof, except that 25% thereof shall be required if the total leverage ratio is between 2.50:1.00 and 2.00:1.00 (in each case, minus voluntary repayments made during the applicable fiscal year), and no such prepayment shall be required if the total leverage ratio is 2.00:1.00 or less.

In the event the Notes are redeemed, repaid or prepaid (including as voluntary or mandatory prepayments described above), such repayments or prepayments shall be made together with a payment premium equal to 3.00% of the amount repaid or prepaid, except that such premium will not be payable in the case of mandatory prepayments made on account of insurance or condemnation proceeds or excess cash flows (and either no prepayment penalty or a reduced prepayment premium shall be payable in the case of prepayments made with the proceeds of certain VAT amounts). In the case of repayments of all or any portion of the Notes on or after the maturity date, such repayment will be made together with an exit premium equal to 3.00% of the amount so repaid.

The Note Purchase Agreement contains customary representations and warranties and affirmative covenants applicable to Gaming Acquisitions, the Company and the subsidiaries of the Company and also contains certain restrictive covenants, including, among others, limitations on: the incurrence of additional debt; provided, however, that Gaming Acquisitions is permitted to incur indebtedness under the Revolving Credit Facility (in an aggregate principal amount not to exceed £7,500,000), liens on property (except those securing the Revolving Credit Facility or certain hedging indebtedness), acquisitions and investments, loans and guarantees, mergers, consolidations, liquidations and dissolutions, asset sales, dividends and other payments in respect of the Company's capital stock, prepayments of certain debt, transactions with affiliates and modifications of the Credit Parties' organizational documents and certain debt agreements. The Note Purchase Agreement requires quarterly compliance with maximum leverage and fixed charge coverage ratios as well as a minimum liquidity covenant. The agreement also includes customary event of default provisions.

On or before the date of the first interest payment due and payable by Gaming Acquisitions in respect of the Notes, the Notes shall be listed on the International Stock Exchange of the Channel Islands and shall remain listed until the repayment of the Notes in full in accordance with the terms of the Note Purchase Agreement.

HGV Fund currently holds 100% of the Notes. As disclosed in stock ownership filings with the Securities and Exchange Commission pursuant to Section 16 under the Securities Act of 1934, HGV Fund owns approximately 17.5% of the Company's outstanding common stock as well as warrants to purchase shares of the Company's common stock. HGV Fund is also a stockholder and investor in Leisure Acquisition Corp., a special purpose acquisition company affiliated with two members of the Company's management.

Revolving Credit Facility

Concurrently with the issuance of the Notes and repayment of the Existing Credit Facility, Gaming Acquisitions, the Company and the Subsidiary Guarantors entered into a Revolving Credit Facility Agreement (the "Revolving Credit Facility Agreement") to provide for a £7,500,000 revolving facility from Lloyds Bank PLC (the "Revolving Facility Lender") to be used for general corporate, working capital and capital expenditure purposes of the Company and its subsidiaries (the "Revolving Credit Facility"), with the Agent acting as security agent for the Revolving Facility Lender (in such capacity, the "RCF Security Agent").

The obligations under the Revolving Credit Facility are guaranteed on a joint and several basis by each of Gaming Acquisitions, the Company and certain Subsidiary Guarantors party thereto and are secured on a first-priority basis (subject to certain exceptions) by a lien granted to the RCF Security Agent for the benefit of the Revolving Facility Lender on substantially all of the assets of each Credit Party, including all of the capital stock held by such Credit Party. Certain Subsidiary Guarantors will accede to the Revolving Credit Facility Agreement within 30 days of closing.

The Revolving Credit Facility requires cash interest payments on outstanding borrowings equal to a margin of 4.00% per annum, plus LIBOR, on the last day of each applicable interest period. In addition, a commitment fee is payable every three months with respect to unutilized lending commitments thereunder at a rate of 35% of the margin applicable to such unutilized commitments per annum. The Revolving Credit Facility is scheduled to mature on August 13, 2021. Subject to certain conditions, voluntary prepayments are permitted under the Revolving Credit Facility and mandatory prepayments are required in the event of a change of control and/or the sale of all or substantially all assets of the Credit Parties.

The Revolving Credit Facility contains customary representations and warranties and affirmative covenants applicable to Gaming Acquisitions, the Company and the Company's subsidiaries and also contains certain restrictive covenants, including, among others, limitations on: the incurrence of additional debt, liens on property, acquisitions and investments, loans and guarantees, mergers, consolidations, liquidations and dissolutions, asset sales, dividends and other payments in respect of the Company's capital stock, prepayments of certain debt, transactions with affiliates and modifications of the Credit Parties' organizational documents and certain debt agreements. The Revolving Credit Facility requires quarterly compliance with maximum leverage and interest coverage ratios as well as a minimum liquidity covenant. The agreement also contains customary event of default provisions.

Hedging Transaction

In connection with the Note Purchase Agreement Gaming Acquisitions entered into a three (3) year, fixed-rate, cross-currency swap which swaps the principal and interest payments that will be payable in US Dollars (USD) under the Note Purchase Agreement to Euros (EUR), in part, and Pounds Sterling (GBP), in part. The swap is provided by Nomura (the "Nomura Swap"). Specifically, with respect to the principal payments under the Note Purchase Agreement, Gaming Acquisitions will swap 1/3rd of such principal payments from USD to EUR and 2/3rds of such principal payments from USD to GBP. Additionally, with respect to the interest payments under the Note Purchase Agreement, Gaming Acquisitions will swap 1/3rd of such interest payments from USD to GBP and 2/3rds of such interest payments from USD to EUR. The Nomura Swap provides for a foreign exchange rate of $1.13935 USD per €1 EUR and $1.27565 USD per £1 GPB.

The obligations under the Nomura Swap are unconditionally guaranteed on a joint and several basis by each of Gaming Acquisitions, the Company and Subsidiary Guarantors and are secured on a first-priority basis (subject to certain exceptions) by a lien granted to the Agent for the benefit of Nomura on substantially all of the assets of each Credit Party, including all of the capital stock held by such Credit Party.

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 June 30, 2018, we earned approximately 61.2% of our revenue in the UK, 20.6% in Greece, 11.5% in Italy and the remaining 6.7% across the rest of the world. During the three months ended June 30, 2017, the percentages were 65.6%, 13.8%, 12.4% and 8.2%, respectively. For the nine months ended June 30, 2018, we earned approximately 64.0% of our revenue in the UK, 16.5% in Greece, 12.5% in Italy and the remaining 6.9% across the rest of the world. During the nine months ended June 30, 2017, the percentages were 68.9%, 6.6%, 14.2% and 10.3%, 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 June 30, 2018, we derived approximately 38.8% of our revenue from sales to customers outside of the UK, compared to 34.4% during the three months ended June 30, 2017. During the nine months ended June 30, 2018, we derived approximately 36.0% of our revenue from sales to customers outside of the UK compared to 31.1% during the nine months ended June 30, 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.

Refinancing of External Borrowings

After the quarter end, we refinanced our external borrowings. For further information, see "-Refinancing of External Borrowings", below.

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 91-day period for 2018 and 2017. The balance sheet date of each fiscal period is June 30. Each of the foregoing periods is herein referred to as a "three-month period."

The nine-month financial periods presented consist of a 273-day period for 2018 and a 279-day period for 2017. The balance sheet date of each fiscal period is June 30. Each of the foregoing periods is herein referred to as a "nine-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 June 30, 2018 and 2017, the average USD: GBP rate was 1.36 and 1.28, respectively. In the nine-month periods ended June 30, 2018 and 2017, the average USD: GBP rate was 1.37 and 1.26, respectively.

In the tables below, the "Days Movement" column represents values relating to the additional six days in the 2017 "nine-month period" as compared to the 2018 "nine-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 91 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 June 30, 2018 compared to Three Months ended June 30, 2017

Revenue

Total revenue for the quarter ended June 30, 2018 increased by $4.6 million, or 14.3%, from the quarter ended June 30, 2017, to $36.9 million, on a reported basis. Favorable currency movements accounted for $2.1 million of the increase, with constant currency revenue increasing by $2.5 million, or 7.9%.

SBG revenue, which is included in total revenue above, increased by $2.1 million on a constant currency basis, or 9.2%, comprised of growth in service revenue of $5.4 million, partly offset by lower hardware sales of $3.2 million.

SBG service revenue increased by $5.4 million on a constant currency basis, or 30.0%, as a result of the continued rollout of terminals in Greece driving a $1.9 million increase and software license sales of $3.4 million into the Greek market.

Hardware revenue decrease was driven by lower hardware sales in the Greek and the Electronic Table Gaming ("ETG") markets of $2.8 million and $0.3 million, respectively. The hardware sales in Greece were nil margin sales.

Virtual Sports revenue increased by $0.4 million on a constant currency basis, or 4.5%, driven by new customer revenue from our mobile remote game server ("Mobile RGS") product and continued growth in Greece, Finland and Poland. Growth was negatively affected by $0.6 million due to a reduction in revenue from long-term Virtual Sports licenses that have now come to an end. Underlying Virtual Sports revenue increased by $1.0 million, or 12.8%. Of which $0.6 million came from Virtual Sports land-based and online customers and $0.4 million from Mobile RGS.

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, decreased from the period ended June 30, 2017 by $1.1 million, or 12.4%, on a reported basis, to $7.9 million. Of this decrease, $0.5 million arose from adverse currency movements. On a constant currency basis, cost of sales decreased by $1.6 million, or 17.4%.

Cost of service increased by $1.4 million, or 32.7%, on a constant currency basis due to an increase in Greece SBG service costs of $1.1 million, driven by the continued terminal rollout, and $0.1 million from additional costs to service UK SBG terminals. $0.2 million of the increase was due to the additional cost of supporting new recurring contracts for Virtual Sports.

Cost of hardware decreased by $2.9 million, or 59.9%, on a constant currency basis due to lower nil margin hardware sales in Greece. 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 $1.5 million, or 10.6%, on a reported basis, to $15.2 million. Of this increase, $0.9 million arose from adverse currency movements. On a constant currency basis, SG&A expenses increased by $0.6 million, or 4.3%. $1.5 million of this adverse variance was due to restructuring costs relating to the senior management changes announced in May (which amount has been excluded from our Adjusted EBITDA calculations set forth elsewhere in this Item 2). This was partly offset by $0.9 million of 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 June 30, 2018, there were 2,383,280 shares subject to outstanding awards and 1,133,207 shares remaining available for future awards. A total of 562,331 shares have been settled (either issued in settlement of vested awards or surrendered to pay for taxes due on settlement of vested awards). 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 $1.5 million in respect of outstanding awards, which was $0.1 million higher than the prior year charge for stock-based compensation due to additional awards being made.

Depreciation and amortization

Depreciation and amortization increased by $1.9 million, or 22.0%, to $10.6 million, on a reported basis. Of this increase, $0.6 million arose from adverse currency movements.

On a constant currency basis, depreciation and amortization increased by $1.3 million, or 14.9%. This increase was driven by additional amortization in connection with new platforms and games going live on SBG ($0.6 million) and an increase of $0.4 million due to machine and machine related depreciation, comprised of a $0.5 million increase from the continued roll out of machines in Greece, partly offset by a $0.1 million decrease from the sale of machines in Colombia.

Net operating income (loss)

On a reported basis, net operating profit (loss) improved from a loss of $0.7 million in the 2017 period to a profit of $1.6 million in the 2018 period, of which $0.1 million arose from favorable currency movements. On a constant currency basis, net operating income (loss) improved by $2.3 million, due to an increase in revenue and a decrease in cost of sales. This was partly offset by an increase in depreciation and amortization and SG&A.

Interest expense

Interest expense increased by $0.1 million, or 2.9%, in the quarter ended June 30, 2018, to $5.1 million, on a reported basis. This variance arose from adverse currency movements of $0.3 million. On a constant currency basis, interest expense decreased by $0.2 million from the quarter ended June 30, 2017. There were higher cash and PIK charges on the existing senior debt due to continued compounding of the PIK interest charge of $0.4 million which was largely offset due to no amortization of debt fees in the current year ($0.3 million in the corresponding quarter of the prior 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 the Earnout Jurisdictions, and share-price movements ($6.25 at June 30, 2018 and $5.50 at March 31, 2018), the charge that accrued in the current quarter resulting from a change in fair value of earnout liability was $0.6 million. In the corresponding quarter in the prior year, the corresponding figure was a charge of $2.4 million.

Change in fair value of derivative liability

Change in fair value of derivative liability decreased by $0.3 million to $0 on a reported basis as a result of the approval of the Second Incentive Plan in March 2018, which resulted in awards granted thereunder being charged as stock-based compensation rather than as a derivative liability.

Net loss

On a reported basis, net loss improved from a loss of $8.3 million to a loss of $4.0 million. This was affected by a $0.2 million adverse currency movement. On a constant currency basis, net loss improved by $4.6 million due to an increase in revenue, a decrease in cost of sales and the change in fair value liabilities, partly offset by an increase in depreciation and amortization and SG&A.

Results of Operations –

Three Months ended June 30, 2018 compared to Three Months ended June 30, 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 between three and 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 June 30, 2018

Our SBG rollout into the Greek market continued, with approximately 4,800 terminals installed as of June 30, 2018. During the period a further 965 terminals were contracted, which form part of our phase two rollout plan to be delivered across calendar year 2018. The performance of our Greek terminals continues to be strong compared to other suppliers during the period.

In the Italian market, a contract extension was agreed for a further four years with our largest customer. The contract included continuing hardware, platform and games supply. The contract also included an increased revenue share due to the Company. Customer Gross Win per unit per day (in EUR) in the Italian market increased by 21.9%, due to new content releases and improved account management.

During the period, another of our major UK LBO customers contracted with us for a further two and a half years. The contract extension includes the redeployment of 120 "Eclipse" terminals during July and October 2018. This extended supplier agreement also comes with no further capital expenditure.

Overall, the size of our Average Installed Base increased 16.5%, to 32,107, due to our continued terminal rollout in Greece and growth from new contracts in the UK LBO estate. Customer Gross Win per unit per day (in our functional currency, GBP) decreased by 5.1% across the entire estate, 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, partly offset by the increase in the Italian market Customer Gross Win per unit per day. Our blended participation rate remained at 6.0%.

SBG segment, Three Months ended June 30, 2018 compared to Three Months ended June 30, 2017