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International Game Technology (NYSE:IGT)

F4Q08 Earnings Call

October 30, 2008 9:00 am ET

Executives

Patrick Cavanaugh - Vice President, Corporate Finance & Investor Relations

Thomas J. Matthews - President & Chief Executive Officer

Analysts

Celeste Brown – Morgan Stanley

Robin Farley – UBS

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Steven Kent – Goldman Sachs

David Katz – Oppenheimer & Co.

Neil Portis – Barclays Capital

Rachael Rothman – Merrill Lynch

Joseph Greff – J.P. Morgan

William Lerner – Deutsche Bank Securities

Justin Sebastiano – Morgan Joseph

Operator

Good morning and welcome to the IGT fourth quarter and fiscal year 2008 conference call. (Operator Instructions) I would like to turn the call over to your speaker, Mr. Pat Cavanaugh, Vice President of Finance and Investor Relations.

Patrick Cavanaugh

Good morning everyone and welcome to IGT’s fourth quarter and fiscal year 2008 earnings conference call. With me this morning are T.J. Matthews, our Chairman and Chief Executive Officer and Danny Siciliano, our Chief Accounting Officer and Treasurer.

Before we begin I’d like to note that during this earnings call certain statements and responses to questions may contain forward-looking information including forecasts of future financial performance and estimates of amounts not yet determined, the potential for growth of existing and the opening of new markets and products, play levels for our install base of recurring revenue games as well as our future prospects and proposed new products, services, developments or business strategies. Actual results could differ materially from those projected or reflected in our forward-looking statements and reported results should not be considered an indication of future performance. IGT’s future financial condition and results of operation as well as any forward-looking statements are subject to change and to inherent known and unknown risks and uncertainties. IGT does not intend and undertakes no obligation to update our forward-looking statements including any comments regarding our earnings expectations to reflect future events or circumstances. All forward-looking statements made in this conference reflect IGT’s current analysis of existing trends and information and represent IGT’s judgment only as of today. You should not assume later in the quarter or year that the comments we made today are still valid. Actual results may differ materially from current expectations based on a number of factors affecting IGT’s businesses including unfavorable changes to regulations or problems with the obtaining or maintaining these licenses or approvals, a decrease in popularity of our recurring revenue games or unfavorable changes in player or operator preferences, for general decline in play levels, decreases in interest rates which in turn increase our costs or jackpots, slow growth in the number of new casinos or the rate of replacement of existing gaming machines, failure to successfully develop and manage frequent introductions in innovative products.

More information on factors that could affect IGT’s future business and financial results or cause us not to achieve our forecasts are included in our most recently annual report on Form 10-K and other public filings made with the Securities and Exchange Commission.

During this call today references may be made to non-GAAP financial results. Investors are encouraged to review these non-GAAP financial measures as well as a reconciliation of these measures to the comparable GAAP results in our 8-K filed with the SEC today, a copy of which can be found on our website at www.igt.com. This call, the webcast of this call and its replay are the property of IGT. It is not for re-broadcast or use by any other party without the prior written consent of IGT. If you do not agree with these terms, please disconnect now. By remaining on the line you agree to be bound by these terms.

With that being said, earlier this morning we reported results for the fourth quarter and fiscal year 2008. Net income in the fourth quarter totaled $52.0 million, or $0.18 per diluted share, inclusive of write-downs of $29.0 million, or $0.10 per share, on certain investments, compared to $123.0 million, and $0.38 per diluted share, in the prior-year quarter.

For the year net income was $343.0 million, or $1.10 per diluted share, compared to $508.0 million, or $1.51 per diluted share, in the prior fiscal year.

The fourth quarter and fiscal year were affected by a number of notable items, the details of which are broken out in our earnings press release which went out earlier this morning. Numerous factors led to weaker operating conditions seen in the quarter, including credit market deterioration, wide-spread economic concerns, and inclement weather. Much has changed in the past few months, however, we remain confident that the company is positioned to capitalize on future opportunities.

Moving on to a discussion of our business segments, first with gaming operations. Our gaming operations business generated revenues of $331.0 million in the fourth quarter, which is down 1% sequentially and 6% year-over-year. Gross margins were 58% for the quarter versus 61% in the prior year.

Our gaming operations revenue and margins continue to see challenging operating conditions with lower play levels seen in most key jurisdictions. Normally our fourth quarter gaming operations revenue see at a 3% sequential increase due to seasonality. Once again, we believe the differential between our expected sequential growth and our actual numbers is partially due to macroeconomic factors affecting play levels.

As seen throughout 2008, our business has also been affected by a shift in product mix towards an increased percentage of lower-yielding stand-alone units in our install base.

For the year, revenues were $1.3 billion compared to the prior revenues of $1.4 billion. And gross margins, 58% for the fiscal year compared to 60% last year. Gross margins for the year were negatively impacted by declining interest rates resulting in additional jackpot expense as well as technical obsolescence charges for fixed assets. Without these impacts gross margins would have been essentially flat for the year compared to the prior year.

The decline in interest rates during the course of the year reduced our gross profit by approximately $25.0 million. We expect this impact to continue as rates are expected to remain low by historical standards for the foreseeable future.

Our install base ended the fourth quarter at 60,500 units, up 400 units over the prior year and sequential quarters. Approximately 74% of our install base is comprised of variable-fee games that earn a percentage of machine play levels rather than fixed daily fee.

Install base growth in the international markets and domestic racino markets was partially offset by reductions in Florida and California Class II markets as they transitioned to Class III for-sale games during the year.

Based on yield threshold considerations, the current reported install base and the historical comparisons have been revised to reflect approximately 900 international units previously excluded. Gaming operations revenues were not impacted by this adjustment in our reported install base.

IGT earned an average of $60 in revenue per unit per day versus $66 in the prior-year quarter and $61 sequentially. For the year, average revenue per unit per day came in at $61, down from $69 in the prior year. The decreases in revenue per unit are due to lower play levels resulting from the current economic environment and a growing mix of lower-yielding stand-alone units.

Now moving on to product sales, product sales revenue totaled $301.0 million for the quarter compared to $310.0 million in the prior year. For the fiscal year revenues were $1.2 billion compared to $1.3 billion in the prior year.

World-wide we shipped 20,100 machines during the quarter, down from prior-year shipments of 23,400. In the fiscal year IGT shipped 72, 700 machines, down from shipments of 105,900 machines last year.

Non-machine revenues comprised of gaming systems, game theme conversions, table parts, and intellectual property fees came in at $94.0 million for the quarter, or 31% of total product sales for the quarter, compared to $118.0 million and 38% of total product sales in the prior-year quarter.

For the year, non-machine revenues were $396.0 million, or 33% of total product sales, up from $384.0 million, or 30% in the prior fiscal year.

Product sales gross margins for the quarter and fiscal year were 54%, up 200 basis points from both prior-year periods.

Breaking product sales down, domestic versus international, first with domestic, domestic product sales totaled $184.0 million on volume of 8,900 units for the current quarter, compared to $186.0 million and 8,300 units in the prior-year quarter.

For the fiscal year, domestic product sales revenue was $732.0 million, down from $787.0 million in the prior year. Units shipped domestically for the fiscal year totaled 35,000, down from 43,000 in the prior year.

Replacement demand picked up modestly during the fourth quarter as IGT sold 4,900 replacement units compared to 3,600 units in the sequential quarter and 4,500 units last year, driven by demand for our new AVP models.

We successfully released five of our six new models during the third and fourth quarter and the last new model began shipping in October. Early feedback from our customers has been positive on these new models and based on current market place conditions, we anticipate replacement demand in 2009 will exceed 2008 levels.

We shipped 4,000 new and expansion units in the quarter, up 200 units from the prior-year quarter. Additionally, revenues from approximately 1,800 machines shipped during the fourth quarter are expected to be included in our next fiscal quarter.

Deferred revenue, including these 1,800 machines, increased approximately $38.0 million during the quarter to a total of $62.0 million at September 30, 2008. The increase is the result of our continued shift toward a more multi-element contracts, including systems and software sales.

Domestic non-machine revenues totaled $70.0 million in the quarter, down from $87.0 million in the prior-year quarter. For fiscal 2008 domestic non-machine revenues were $299.0 million, up from $295.0 million in fiscal 2007. The fourth quarter came in lower mostly due to the reduction in part sales comprised mostly of game conversions and system revenues.

We anticipate we will see stronger system sales in 2009 driven by an increased number of installations scheduled. We expect this to be partially offset by reduced parts revenues as conversions sold for legacy platform products will be reduced as a result of our migration of development efforts to the AVP platform.

IGT sold 8,900 domestic units in the quarter and 35,000 for the year compared to 8,300 in the prior quarter and 43,000 in the prior fiscal year. We estimate our ship share on new and replacement orders of 100 units or more at 61% for the quarter.

Domestic average revenue per unit was $20,600 for the fourth quarter compared to $22,400 in the prior-year quarter due to lower non-box revenues in the quarter. Sales from machines used by our AVP platform comprised 78% of total North American machines shipped during the fourth quarter and 63% for the year. We expect AVP machines to comprise well over 80% of our product mix going forward.

International product sales revenue totaled $118.0 million on volume of 11,200 units compared to $124.0 million and 15, 100 units in the prior-year quarter. For the fiscal year, revenues were $459.0 million, down from $474.0 million in the prior fiscal year, while units sold for the year were 37,700, down from 62,900 units in 2007.

The declines in both the quarter and the year were mostly due to Japan, where units shipped in the fourth quarter were 3,000 compared to 7,200 in the prior-year quarter and 6,500 for the year compared to 29,800 in 2007. These declines were somewhat offset by a record year of shipments in Latin America.

International non-machine sales were $25.0 million, down from $31.0 million in the prior-year quarter. Non-machine revenues for the year were $97.0 million, up from $89.0 million in the prior fiscal year. The decrease in the quarter was driven by a decrease in parts demand, while the increase for the year was mostly due to higher system sales.

International average revenue per unit in the fourth quarter was $10,500, up 28% over the prior-year quarter. For the year, international RPU was $12,200, up 64% over the prior fiscal year. The RPU increases were driven by fewer lower priced machines shipped into Japan and the U.K.

Product sales will continue to fluctuate quarter, depending on the geographic mix of sales and the mix of non-machine revenues. With the availability of our new six models and a geographically diverse pipeline of new and expansion projects, we expect to see improved machine shipment levels over the next few quarters.

Moving on to operating expenses and other income, total operating expenses were $204.0 million for the quarter compared to $179.0 million in the prior-year quarter.

SG&A totaled $125.0 million, an increase of $20.0 million over Q4 last year. We saw higher legal and compliance fees as well as higher staffing-related costs in the quarter. Bad debt provisions totaled a net expense of $4.0 million compared to $2.0 million in expense in the prior-year quarter.

R&D expense totaled $60.0 million for the quarter, up $54.0 million from the prior year. For the year our investment in R&D was $223.0 million, up 10% year-over-year.

Depreciation and amortization within operating expenses totaled $20.0 million for the quarter, flat with the prior-year quarter. For 2008 depreciation and amortization was $77.0 million, down from $80.0 million in 2007.

Total depreciation and amortization, inclusive of depreciation on our game ops assets that is recognized in cost of sales, the game ops, was $76.0 million for the quarter, up from $67.0 million in the prior-year [quarter] and $286.0 million in 2008, up from $266.0 million in the prior year.

Operating expenses as a percentage of revenues were 32% this quarter versus 27% in the prior-year quarter and 30% in the sequential quarter. For 2008 operating expenses were 30% of revenues compared to 26% in fiscal 2007.

Our SG&A expenses are being carefully scrutinized in an ongoing company-wide strategic review and we expect them to be at a lower run rate beginning in the second quarter of 2009. We continue to invest in future innovations and our server-based initiatives that is part of this strategic review. We are carefully considering the proper level of R&D spending given the current market place conditions. T.J. will have some further details later in the call on this topic.

While 2008 saw IGT benefit from the weakening of the dollar versus major foreign currencies, the trend has noticeable turned in recent months. IGT’s operating income for 2008 was approximately $19.0 million higher when using exchange rates from 2007 as a benchmark, but due to strong rebound in the dollar we could see a negative impact to our operating income of similar or greater magnitude in 2009.

Other income expense net in the fourth quarter was a net expense of $47.0 million, up from $2.0 million in the prior-year quarter and a net expense of $69.0 million for the year compared to income net of $5.0 million in the prior year.

During the quarter we recognized $29.0 million in write-downs on investments in both China LotSynergy Holdings and Progressive Gaming International, based on the decline in their respective market values driven by tougher market conditions.

Moving on to the tax rate, our tax rate came in at 50% in the fourth quarter and 42% for the year, compared to 37% for both prior-year quarter and the year. The main driver for the increased rates came from non-cash charges related to investments I previously mentioned as we were not able to recognize the tax benefit of these capital losses for tax purposes. Without the charges, the tax rate for the year would have been 40%.

We estimate our annual tax rate for fiscal 2009 will be approximately 40% without any one-time charge backs or nondeductible book charges.

Our tax rate for Q1 should be lower than the remaining quarters of 2009 due to the impact of the extension of the R&D tax credit, which the President recently signed into law.

Moving on to the balance sheet, cash equivalents and short-term investments, inclusive of restricted amounts, totaled $374.0 million at September 30, 2008, compared to $401.0 million at September 30, 2007.

Total debt was $2.3 billion at September 30,2008, compared to $1.5 billion at the end of the previous fiscal year.

IGT will take a prudent and conservative approach to maintaining necessary liquidity in these volatile times. Our credit facility remains at an attractive source of capital for IGT with a current borrowing rate of under 4%. The undrawn capacity on our line totaled $1.2 billion at September 30, 2008. We believe that cash flow from operations and capacity on our line of credit are adequate to finance our future capital deployment.

During 2008 we repurchased 25.5 million shares at an aggregate cost of $780.0 million. Our outstanding share count stood at 294.7 million shares at September 30, 2008. We have 7.7 million shares remaining under our stock repurchase authorization as of September 30, 2008.

During fiscal 2008 IGT deployed back to shareholders a total of $955.0 million through both share buybacks and dividends.

While we believe at today’s price our stock is an excellent value, the current environment puts a premium on liquidity and as a result, until we see improvement in the credit markets, we will judiciously deploy our capital to preserve maximum flexibility.

Working capital totaled $733.0 million compared to $596.0 million at the end of fiscal 2007 with average days sales outstanding of 98 days and inventory turns of 2.5x.

Inventories have increased by $74.0 million since the end of 2007 as we ramp up production of our new AVP products into fiscal 2009.

In fiscal 2008 IGT generated $516.0 million cash from operations, down from $822.0 million last year. The decrease is primarily attributable to lower net income, changes in working capital, and additional prepayments made to secure long-term licensing rights to recognize brands, which help favorably differentiate our products in the market place.

Capital expenditures for the year totaled $298.0 million compared to $334.0 million in the prior year. The decrease is mainly attributable to the prior-year purchase of a corporate aircraft and construction of our Las Vegas campus.

Capex is expected to trend in a quarterly range of $60.0 million to $75.0 million going forward.

That concludes my prepared remarks regarding IGT’s fourth quarter and fiscal year. Thanks for your time and attention. I will now turn the call over to T.J. for his closing remarks.

Thomas J. Matthews

Good morning to everyone. Before opening the lines to questions I would like to make some comments regarding our business and its outlook.

Obviously this last year we faced some of the most difficult marketing conditions we’ve seen in our history and our current share price clearly reflects that the market conditions demonstrate those concerns of all gaming companies, including the health of the consumer, the health of the operators and our ability to sell to them.

But despite these concerns, IGT saw its second highest year of revenue, up just 4% from last year’s all-time high. And this was done in a year in which IGT saw the lowest level of North American unit demand since 1993, which obviously speaks well to our efforts to diversify our business and its sources of revenue.

Our fourth quarter EPS after charges is down $0.10 from last year. About $0.05 of this difference comes from the reduced play levels and higher tax rates, factors that are generally beyond our control but which in time could change favorably for IGT. The remaining $0.05 comes from our cost structure which we are targeting in an ongoing review of our organization. We are close to concluding the first phase of this strategic business review that I mentioned in our last earnings call.

We are going to make strategic changes to increase productivity and responsiveness to the customer and its market place needs. We are going to rationalize expenses and we have already started to put that into place. The next step is to adjust headcount, which will reflect current and our expected future market conditions.

We are targeting initial costs savings of about $20.0 million to $25.0 million per quarter compared to our current levels and we expect the impact to begin in the second quarter of 2009. We are continuing to take a look at expenses throughout the year as we continue to have a goal of 30% operating margins.

In terms of trying to give some guidance and what our revenue growth might look like, our visibility is limited at this point. We are confident that we are going to ship more domestic replacement units due to the new AVP machines, due to the early reports of strong performance. We’re excited about some of the products we have there, not only with the cabinets and game design, but some of the unique technology like the MLD. And we know that there are going to be global opportunities that are going to remain very attractive and are going to be a large part of our business in the future.

So with that, to talk about guidance, we see our customers continue to make purchases of gaming equipment and utilize our gaming machines in their own operations but their financial flexibility is clearly constrained in most cases and we also face numerous head winds that Pat had mentioned, not only reduced play levels from the consumer but lower interest rates and volatility in foreign exchange rates.

Until these head winds subside somewhat, we would anticipate that our EPS would probably come in at the lower end, or maybe even slightly below, our previous guidance of $0.30 to $0.35. that’s obviously a topic that we will continue to revisit on future earnings calls.

We are hopeful that play levels will start to stabilize and maybe even grow and that the impacts of our cost reductions also favorably impact future guidance that we’re able to give.

With all of that, I am going to open the line to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Celeste Brown – Morgan Stanley.

Celeste Brown – Morgan Stanley

Given all the press recently in regards to your litigation, could you just give us your views on your strategy going forward? Are you focused on dealing with validity or infringement with the patents or do you feel that the whole case can get overturned at this point?

Thomas J. Matthews

I think there are a couple of questions there. The first is kind of what is our view on intellectual property and the rationale for the litigation to begin with. And of course our business, in our minds, is best pursued when in fact we have intellectual property that protects its margins, protects exclusivity, allows us to have a competitive advantage.

And there is this basic philosophical question within the industry of, “Does IP matter?” And we are clearly in the camp that IP matters and there are others out there that want to undermine that point of view.

And so unfortunately it means that we have to be fairly vigorous in our enforcement and even do something that we would prefer not to, which is pursue litigation. And I think we have said in the times past, litigation is the worst business choice one can make in that you have a very time-consuming, expensive, uncertain process in which you are subjecting yourself. But nonetheless it is necessary if you are going to pursue a business strategy in which intellectual property is important.

So in terms of the case relative to Bally, as you know, there have really been three cases outstanding between the companies. I guess four cases outstanding between the companies. One successfully resolved in its entirety, in our favor, finding that Bally had infringed patents that were issued to the inventor, Ernie Moody. And damages were paid to IGT in accordance with that ruling.

We find ourselves in one case with Bally where the case has been dismissed in our favor and in another case against Bally where it has been dismissed in Bally’s favor. In both instances I would say that the final word has not been given, that we are going to go to an appellate process. The appellate process is a special court of appeals established in Washington, D.C., specifically to hear patent cases. That’s their area of expertise and that in this appellate process they have the opportunity to hear all arguments, in effect for the first time.

And so in the case of the certification indicated to us by the judge in the case relating to our real patent case against Bally, the judge has indicated he will certify that all rulings be made available to the appellate court for their review. This includes the Markman hearing, which is the interpretation of the patents themselves, the claim construction and what it is as a result of the scope of the patent. It includes all the rulings made on validity and non-infringement.

I think at this point we don’t have much choice but to pursue the appellate process given that we do have patents that were found to be invalid by these initial rulings and we need to go and recover those patents, firstly.

As a second priority, we still are very keen on being able to preserve as much exclusivity as we can for our wheel-based products and still want everyone to be on notice that we believe that these patents will be found valid, that the scope, at a minimum, has been previously defined in the Markman hearings but may in fact be broader. And that we are going to continue to vigorously pursue our rights to practice that, our invention, on an exclusive basis.

That said, I think we are well aware that the world of patents is going to change some and that there is going to be much encouragement from the courts and from the process itself to make certain technologies available to an entire industry.

I would remind folks on this call that when we report our non-box revenues, one of the major components of that is license fees that we realize from the industry for licensing our intellectual property across the board. As you know, prior to the GSA protocol, the protocol was made standard and available by IGT. The cashless technology that makes ticketing standard on the casino floors is facilitated by a pool patent lead by IGT’s intellectual property licensed by IGT on behalf of a number of different inventors and owners of those patents.

I think that’s going to continue to be a core strategy of our company and I think for people to continue to expect outsize margins and outsized returns, in fact, need to demand that continue to be a part of our strategy.

Operator

Your next question comes from Robin Farley – UBS.

Robin Farley – UBS

You have had some operators out there kind of talking about renegotiating revenue sharing contracts on their floor and I wonder if you can talk about whether you’re seeing that and if so have you seen that with a lot of the operators or we just at the beginning of maybe a period of a lot of renegotiation? Just to get your take on those comments.

And then also if I can just get the geographic breakdown that you often give.

Thomas J. Matthews

The first question, I think that there is no doubt that the casino operator environment is challenged right now. And challenged for two reasons. We have a common customer in the consumer. And we have seen play levels decline really since last November. They accelerated a bit in April and appears to have accelerated a bit further in October.

I really am of the mind that that’s going to stabilize here at some point, maybe as soon as people get from in front of CNBC for purposes of watching what’s next in the financial crisis or CNN to watch what’s happening in the election process, that people will get comfortable about their state here at some point. Whether that’s the middle of 2009 or the end of 2009 I think is uncertain, but we will reach that point.

And when that happens, the operators themselves will have a much better basis for predicting the health of their business, what the revenue outlook is and how they need to be capitalized and their expense structures need to be put into place to support that business level.

In the meantime, you have this issue in which the operators are forced to potentially de-leverage, or at least reconsider their capital structure. It causes them to be a little stingy with capex, or at least we would anticipate that it may cause that. It also causes them, in some cases, to offer much more scrutiny to their operating expenses. And so it does cause for some ongoing conversations to take place between us.

The general background of those conversations is nothing new. The idea of what is a fair financial arrangement for us to provide our recurring revenue product has been the source of conversation ever since we introduced Megabucks 23 years ago. And I expect that it will continue to be an ongoing discussion prospectively.

And I’ve really seen no difference in the desire for folks to address that recently. There are certainly some folks who are experimenting with what is the necessary level of participation games on their floor, does that move play to a smaller base or should they have more games to accommodate peak demand. In Las Vegas in particular, where play levels are down at a greater percentage than that of other markets, I think you’re seeing even more of the experimentation and yes, some of that is being used for purposes of price discussion.

But I don’t think that it is anything that is extraordinary or necessarily contagious. It’s just part of the ongoing business relationship that we have with all of our customers, and with all of our customers I think we have a real opportunity here to really demonstrate how much of a partner IGT is, maybe suppliers in general but IGT in particular. Because we have a balance sheet that helps them, I think through a difficult time where capital is dear, to navigate their floors in a way to keep them fresh, stay competitive, get new product deployed, both in our game ops business and in our products sales segment. And as a result gives them kind of a competitive advantage or allows them to at least not flip, despite the fact that they’re dealing with much bigger capital issues in the background.

So this is one of those situations where though it may be a difficult immediate environment, offers kind of a long-term opportunity for IGT to secure longer-term relationships with each of its customers.

Patrick Cavanaugh

And on the domestic breakdown of product sales, Western region was 3,500, Central region was 3,400, Eastern region was 900, and the balance was Canada for a domestic of 9,000 units.

Internationally we had 800 in Europe, 1,900 in Australia, 3,500 in the U.K, 3,000 in Japan, Latin America was 1,850 and the balance was Asia and Africa.

Operator

Your next question comes from Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Do you want to give an update where the CFO search is?

Thomas J. Matthews

As you know, Steve Morrow has stepped down as Chief Operating Officer of IGT. It has caused me to kind of reconsider the role that I should have near term. Especially given some of the operating challenges and as you know, our issues are three-fold.

We have an expense structure issue relative to a flattening revenue and outlook and need to right-size expenses as a result. And we’ve given some guidance on our ability to maybe get to $100.0 million or greater of cost reductions over the course of the next quarter, that we have some issues relative to the economic climate which we just have to wait and get through as best we can. We’re positioned to be able to do that.

The third of the big issues is, on this 510,000 machine install base of IGT’s, that for the most part is legacy line which is based on our 8960 microprocessor offering, and what we can do to incent operators to reinvest in those positions with new equipment purchases from IGT.

And there’s really only three ways for us to do that. The AVP launch so that we can continue to increase the functionality and features so that platform is one set. Features like MLD which will be a big part of our G2E offering, we think really distinguishes our platform from that of any other competitor, offers much more flexibility, and is going to offer unique game implementation that, again, distinguishes not only our video capability but also offers some flexibility relative to real slots and the ability to deliver kind of network functionality to real slots.

Then you also have games still at the core of every company and we are reorganizing our game effort so that we have much more of a studio approach, which means a lot greater number of smaller teams focused on specific categories, whether they be customer set game type, the pricing model, that will be geared with a specific charter that allows us, I think, to be more targeted with our game development.

And eventually, once this game studio is in place internally, will probably allow for greater output because it is going to allow for more internal development, when it is moved to common platforms. For instance 50+ games developed every year in Australia, not made available in North American, we will resolve that problem.

And then secondly, we will have this platform in this studio approach held externally. And it will allow for a number of other outside game developers to bring games to market there. So games is still very important.

And of course we still have this SB vision to deliver. The idea that you’re going to have network functionality that has to be had for you to improve a customer experience or implement efficiencies into a casino operation. And I really believe that you are going to see casino operators re-emerge from this current climate with a very specific focus on improving efficiencies and of their operations and so that’s an area where we think we can be very helpful with this SB offering.

And all of those require a lot of attention. And so I’m going to be more engaged in operations than I’ve been in the last couple of years. Kind of collapse the CEO and COO’s thoughts into a single effort. It does mean that I need to get some jobs filled.

I think we will have the CFO job filled by the end of November. And I anticipate that other jobs that we have outstanding are already reasonably well staffed but the one place I have to work on is the product team and I would expect that throughout November, really as part of G2E, that you can expect to see a couple of additional moves there.

But already I think we feel very comfortable that we have moved some engineering around so that the lab and network systems and games and platforms are led by the right engineering teams, that we’ve led product management around and really are making sure that they’re more technical in nature in terms of defining the product offerings that we have, that we have ownership of each of the product effort.

And of course we’ve moved this game development effort around. So I feel fairly comfortable that organizationally we are focused on the right things and a matter like the CFO is not at the top of the list of things to do. But it is something that needs to get done and as I said will likely be done by the end of November.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Could you break out the other income line?

Patrick Cavanaugh

The breakdown on other income and expense is interest income 16.4, interest expense of 27.1. and then other of 36.1 with the vast majority of that being made up of the write-downs on CLS and TGIC and the FX loss.

Operator

Your next question comes from Steven Kent – Goldman Sachs.

Steven Kent – Goldman Sachs

As much as we have heard from some of the larger casinos about them wanting to remove participation games or cutting their capex, maybe you could give us more color from your other base of customers, including Native American and regional casino operators who maybe are less financially stressed and what their appetite is for replacing machines or embracing some of your technologies. As and you and I have talked about before, T.J., a slot machine is the highest return potential capex you could put on a floor and certainly participation is nearly infinite, so I’ve never really understood that even from the larger companies, but what are you seeing out there on some of these other players.

And the one thing we’re all wondering a little bit on the $20.0 million to $25.0 million expense reduction seems significant. Why is it taking longer to implement than maybe I would have thought?

Thomas J. Matthews

I will answer the second question first. It’s on expense reduction. We wanted to make sure that we did it right, that we’ve spent about $700.0 million in operating expenses in the course of 2007, got ourselves to a run rate of $800.0 million or so by the end of this fiscal year 2008, and it was too much. Obviously it was done in anticipation of revenue growth that has been deferred and so we need to reinvestigate costs.

Much of that cost reduction is a reduction in staffing and we wanted to make sure that we did with the eye that it was gentle as possible with our employees. Much of that situation is management-created and not necessarily the result of not every individual at IGT working very hard. And so offering first an early-retirement program and then following that with the involuntary separations was our plan. All of that is going to be accomplished by the middle of November and that will manifest itself in much of the cost reduction.

But the cost review doesn’t stop there. We are looking at every expense and re-focusing IGT on the idea that expenses matter. So, it’s cost of goods, SG&A, R&D, other expenses, taxes. Five big categories for us to have focus on making sure that whether it’s access to capital or it’s better planning from a tax perspective, it’s making sure that our R&D priorities are correct, that the SG&A staffing supports the current level of business, that our cost of goods demonstrates efficiencies wherever possible, all of that is being focused.

And so I really expect that we will exceed that run rate as the course of the year progresses and that $175.0 million a quarter or less still is the goal in total operating expenses. And so it may seem like it’s taking a little while but maybe it just took us a little while to say that we were committed to it, which we did last call and I think got on it pretty quickly here with kind of this final action in November.

As it relates to where we are in game ops install base, you know the casino install base was stable throughout the year. We ended the year at roughly the same number of units as we began the year. And that reflects the fact that some operators are, at any given time, removing units and in other instances operators are increasing the number of units. And the ones that are removing units gets lots of attention and the ones that are adding units don’t.

And in the case of an environment where there are operating expense constraints and there are capex restraints, you would expect that as much as certain operators are focused on how to reduce that activity that at least some of them happen upon a formula of actually increasing the amount of operating leases that they do with a company like us.

And so I actually think that you can expect that it is going to continue to be imbalanced over the course of the future and that there is going to be, as you said, individual markets, individual customers, that are also not going to just be looking at how to keep their floors fresh through different pricing mechanisms but also are still flourishing and still are looking for ways to better satisfy their customers. And so it’s up to us to really continue to be focused on product development that caters to that space.

And I will say that maybe that is what we have done a little bit less this last year than we should. There should be much more focus, there should always be much more focus on the game ops business and the product sales business, that should be our freshest and our best product. We should be able to have great launches there on a fairly regular basis and we need to do a better job. I think we will demonstrate that we are back on track, we’re doing a much better job this coming fiscal year.

I will also remind people about the install base. This last year we lost 4,000 machines. You saw us increase our install base year-over-year 400 machines. We lost 4,000 machines, with Class II machines being replaced by Class III machines. That took place in Florida, it took place in California, it took place in Oklahoma. And despite those machines being lost, and it affects mix and yield negatively, all of those machines were replaced by new deployment in other markets.

So again, I think the diversity of opportunities that we have been able to pursue relative to game ops really causes that market to be very stable. And so the top line issue that we have there has not been a creativity issues, it has not been a pricing issue relative to our customers. It really does reflect play levels and the issue with gross margin have to do much more with interest rates than any other activity. And so people should be comfortable that that, as the core of our business, remains relatively healthy.

Operator

Your next question comes from David Katz – Oppenheimer & Co.

David Katz – Oppenheimer & Co.

I wondered if you could just share some thoughts on capital use. You have been a very active repurchase of your own stock and obviously many things have changed in the last four quarters. If you could give us your philosophy going forward.

And then Pat, if you wouldn't mind just going back over what you said about your tax rate for 2009, I missed some of that.

Thomas J. Matthews

I think our capex priorities haven’t changed much at all. We have to be more mindful of availability of capital than we’ve had in times past. The good news for us is that we really have no major refinancing event until the end of 2010. December of that year is when our bank facility expires.

Between now and then I think we can expect that the convertible bonds that we have outstanding are put back to us and so we need to have the financial wherewithal to redeem those.

But realistically, our priorities always have been the same, which is first and foremost how to reinvest in our business and we know that the deployment of a gaming device into our game ops business has extraordinarily good returns and we want to be able to do that as much as possible.

We are going to have to do some of that as we migrate, ourselves, to the newer platforms, continue to add functionality and feature steps to keep those 61,000 machines fresh and hopefully be able to expand that install base.

But we also think that there is some opportunity for us to deploy capital, as we said, to strategically align ourselves with our customers. We have done a really good job in IGT Capital, doing that on a discrete basis for kind of uniquely situated customers. I think we have an opportunity to do more of that now for all of our customers. Whether that has kind of change pricing philosophies, change credit philosophies, it’s the ability to maybe deploy more machines under different kinds of lease arrangements, that still is the priority for how we use capital.

Beyond that, we obviously want to continue to expand our business and so we said that whenever we can acquire things that make us better, we want to do that. And so acquisitions of technology and intellectual property and other know-how, new markets or expansion of our product lines, are all things that have been at the core of our transaction activity in the past.

We have had a particular focus, as you know, on acquiring systems knowledge and continue to expand the scope of that business, both in terms of its product line but also in terms of kind of the effort and the brainpower that is associated with that. So that really, the expansion of our business, is priority number two.

The default use of capital, which we have always said that we will not build up capital positions at IGT in a nonsensical fashion. We believe that we have enough cash to operate the business on an ongoing basis and excess capital should be returned to the shareholders. That returning to the shareholders is done through a reasonable amount of discipline in the form of a dividend and it has also been done in a reasonably disciplined manner relative to share repurchase.

Our philosophy to share repurchase, the idea that management here wants to increase its percentage of ownership, maybe even own the last shares of stock, remains the same. And so though we have to be mindful that right now companies are paying an enormous price when they find themselves in illiquid positions, and we don’t ever want to subject IGT shareholders to such a situation, at the same time I think that we have the financial wherewithal that at least on a modest basis we can consider all the past practices prospectively.

It may be that we wait a quarter or two just to be certain on a couple of those fronts. But nonetheless that we have enough flexibility that our philosophies don’t change much.

Patrick Cavanaugh

On the tax rate we estimate for fiscal 2009 it should be about 40% which is what it would have been for the year had we not had the one-time charges for COS and EGIC.

Operator

Your next question comes from Celeste Brown – Morgan Stanley.

Celeste Brown – Morgan Stanley

How much are you spending in excess of normal on legal right now, related to this case?

Thomas J. Matthews

Not much. Unfortunately we have been in litigation on this particular case since 2004. So the expenses that we have incurred this last year planned for 2009 have been about the same as the run rate they’ve been throughout that period. It’s still think to what we think our IP efforts have been.

The caseload is a little broader right now in terms of the number of IP suits that are outstanding. But nothing that radically changes the profile from 2008 to 2009.

Celeste Brown – Morgan Stanley

On your cost savings, you talked about $100.0 million in costs but your cost structure is so variable. Do we think about it looking at fiscal 2008 costs and subtract $100.0 million or look at fiscal 2008 and grow it and subtract $100.0 million? Or maybe you can give it to us in terms of percent of revenues?

Thomas J. Matthews

The goal is to get to 30% operating margins. And we can get to 30% operating margins with gross margins of let’s say 55% as a target. And operating expenses comprising somewhere in the neighborhood of 25% of revenues as a result. I think that’s where we need to get.

In the meantime, without reference to those long-term goals, we just said that the run rate of about $175.0 million a quarter, which gets us back down to $700.0 million worth of operating expenses on an annual basis, is about where we need to be. And that represents a $100.0 million less than what the run rate is here at the end of the quarter. At the end of the quarter we did $205.0 million or something like that but as you know there were some events that were somewhat out of the ordinary built into those numbers.

Operator

Your next question comes from Neil Portis – Barclays Capital.

Neil Portis – Barclays Capital

On the 8960 cabinets, if you’re going to stop producing new games how do you ensure that you replace those one-for-one with AVP or MLD cabinets. Doesn’t that put some floor space up for grabs.

And what share are you expecting for some of the new openings, Encore or Aliente?

Thomas J. Matthews

I think that’s the biggest question outstanding is not so much whether or not we will replace those machines or time. The industry will replace those machines and not necessarily when. That gets sorted out based on our ability to develop products. The question is what is IGT’s ability to maintain that floor share. And that is all of the internal focus is how do we get to one-to-one replacement.

I think that there is a mindset right now on the operators that we are the default provider for replacing those units but we have clearly understood that we put up for grabs that install base by no longer supporting 8960 game development.

And that was not a decision made lightly. That was a decision that was driven partly by the technical realities of that microprocessor no longer being available and supported by its manufacturer. And so it was time for us to change platforms.

But we need to do the job necessary for us to show that we can replace, particularly Video Reel, back up at that 40% share that we have on an install base when our ship share is probably somewhere close to the 25% in that particular category. So we have got to do a better job in game design there. But we also have to a better job erecting IP barriers and other barriers to entry. We think MLD is it. We think there are some other things we will be doing competitively.

Some of the game play mechanics for instance, where we have multiple games in a single game screen are really very interesting and I think that G2E will be all about what AVP is today and will become and what is the feature of network floors and how we get there faster, not only with those floor-wide deployments as we’ve got in place for CitiCenter, but SBX as well.

As so I feel that there is probably a little slippage in 2009 in terms of one-for-one replacement, but that by the end of the year we’ve solved that and that we are the one-for-one replacer.

I will remind everybody that I think on the call we may have already said it but if we haven’t, our share outside of replacement is fine. I think for the quarter is was 51%, in terms of new and expansion units, that when you go into new properties like Aliente or Encore, our share in Las Vegas in generally in the 70% range. That is still the range for a newly deployed floor. IET is the default provider for much of that.

Our issue is margin. Our issue is that on a 60% floor can we support the play demand necessary for us to grow that install base. Or even support that install base in a static environment. And right now the issue has been, no, we have been losing a point or two of floor share a year now for a couple of years. It is reverting back to normal, but nonetheless we find it as unacceptable as the investment community does, and so intend to remedy that and feel fairly comfortable that over time the 60% or so can be maintained. But it has to maintained with some amount of competitive advantage in Video Reels.

And the industry is troubled to try to figure out ways to really differentiate that product one from another and we’ve been a part of that. Hopefully G2E will show that we have come across some solutions there.

Operator

Your next question comes from Rachael Rothman – Merrill Lynch.

Rachael Rothman – Merrill Lynch

I think historically you had targeted a net debt leverage ratio around 2.5 to maintain your investment grade rating. Can you talk about that in terms of just where your priorities are? We have you slightly above that but given where your share price is it seems like it would be a pretty decent trade off still.

Thomas J. Matthews

One of the things that hasn’t come up on the call is deferred revenues. Deferred revenues grew this last quarter $38.0 million. That means that there is $38.0 million worth of product shift that is not recorded. And the reason for that is more and more of our product is going to be subject to software rules for revenue recognition where realistically it is just fine. It recognizes the fact that we are shifting more and more of the value proposition away from hardware and its dependency on a hardware cycle towards the delivery of software and systems and the functionality that comes with those kinds of application.

And so that should get some attention because the question is how healthy are we. And though we operate in a difficult environment the answer is we are healthy. And so as we take a look at capital structure we have to be mindful that there is this enormous penalty to pay for an illiquid position and so we have to manage liquidity more carefully than we have had to in times past. But the fact is we remain under-leveraged, our stock in our minds remains undervalued, and the opportunity to continue to recapitalize to reflect that is still of extraordinary interest to us as a management team.

And so we are still on a net-debt basis somewhere less than 2x, 2.5 x remains our goal. We think that’s probably about the sustainable rate. In the normal course our borrowing capacity is substantially greater than that. Unfortunately today we are not in ordinary times.

And the one thing I don’t know and I think that we have to be a little bit careful, is I don’t think that there is a lack of availability for capital for us right now but if there is major restructuring that goes on within the industry in general, that may change capital availability to the entire industry, us a part of it.

And so that causes us to maybe be a little more cautious. But look at the goals. As I’ve said before, this management team wants to increase its ownership and we can at least partly accomplish that not only through our own activities, which as you know, this management has increased its ownership directly, but we can also increase it in proportion to the overall shares outstanding by decreasing the number of those.

And so that’s a big part of our ongoing strategy and we feel comfortable about the health of the business in supporting that.

Operator

Your next question comes from Joseph Greff – J.P. Morgan.

Joseph Greff – J.P. Morgan

You talked about domestic ship share in the 4Q. In your prepared comments you said ship share was 51% of orders for the 100 or more units. How much of 100 more units accounted for the total 8,900 of domestic units shipped and what’s the overall in domestic ship share number?

Patrick Cavanaugh

The comment I made was that that was a blended rate between new and replacement orders and it was on 100 units or more. I apologize I don’t have the breakdown but my recollection is that it is probably about comprised about 80% of the total, with the shipments of 100 or more.

Thomas J. Matthews

And I think you can say our ship share these days is probably a little bit below 50% and the disconnect between what our ship share is relative to our install share and what our share is in replacement versus that of new and expansion is what gets the focus here in terms of our product efforts.

Joseph Greff – J.P. Morgan

And when you look back at the statistical 4Q and you look at the revenue per diem on the game op side, how much of that year-over-year decline related to mix and the removal of higher yielding units versus play levels?

Thomas J. Matthews

The majority of it is play levels. We can’t say that mix and price don’t play a role, they do, but I would say the majority of it is overall play levels in the industry.

Operator

Your next question comes from William Lerner – Deutsche Bank Securities.

William Lerner – Deutsche Bank Securities

You talked about I think a fiscal second quarter timing for the cost reductions, then you talked about something starting or happening in November. When will you start to see charges [overtalk]?

Thomas J. Matthews

To be clear on that, the impact of the cost reduction is expected to begin in Q2 but the activity required to get there is a Q1 event, meaning this quarter. And as a result the charges associated with that will be this quarter.

William Lerner – Deutsche Bank Securities

And on the tax rate you gave, it was something like 40% you used going forward. And you earlier mentioned something about the R&D tax credit. Are you saying we are going to see a 40% organic rate including the benefit of the R&D tax credit or how do we think about that?

Patrick Cavanaugh

You will probably see a slightly lower tax rate in Q1, in the December quarter because we will have the three quarters from 2008 that will pick up so you will have to catch up, so the rate should be slightly lower than 40% in Q1 and then the rest of the year would be more at that 40% rate.

William Lerner – Deutsche Bank Securities

And T.J., Japan, Reg. 5, any sort of change in stance about allowance for additional volatility? Where are we at or do we assume several thousand units a year until at some point something structurally changes?

Thomas J. Matthews

If you think of our markets around the world, we had great years in Europe, Africa, Latin America, and Australia. And we had okay years, or less, in North America, Asia, U.K. and Japan. And of course the management’s job there is to figure out how to keep the good times rolling in those first four geographic areas and how to remedy the environment of the next four.

And we believe we have reasonable strategies for North America. We’ve talked about that from a product prospective. The U.K. has a much greater focus on content delivery and operating units and than it has in times past. The cyberview transaction helps that. Asia is continuing just to try to increase share but also trying to introduce higher pricing mechanism into those various markets. And as you know, we had an eye on China about maybe establishing a video lottery that has had a setback and resulted in this write-down but we still feel very optimistic that we can expand that region and that we are going to be well positioned to capitalize on that.

In Japan that whole Reg 5 issue has been unique in that it has really driven down the overall size of the market considerably, a market that was in excess of 2.2 million units is now down to somewhere in the neighborhood of 1.5 million units. But those 1.5 million units still do get replaced, by law, every three years. And so there is a market even though it’s smaller.

The problem with that market is that play levels are down so much on those machines that the operators are in distress as well. And the operator environment has to be sorted out. It hasn’t gone unnoticed and I expect that the government will not necessarily relax Reg 5 but maybe enforce it more to the letter as opposed to over-enforce it.

Meaning it that some of these rules on volatility, some of the difficulties getting games approved, hopefully will improve allowing for much greater numbers of game introductions. This last year saw us only introduce two games to market. And if we can get greater numbers of games into that market, as well as have more success in the number of units shipped, that would have an enormous positive impact on us.

The one thing that did happen this past quarter that is not obvious is that although we remarked on 3,000 machines sold or our last title, we actually shipped well in excess of 7,000 units of that title, the remaining units all under a form of lease. It’s a lease-to-own kind of arrangement, but nonetheless it’s not booked as a sale by us. It’s booked as lease revenue until it’s booked as a sale. Our hope is that it stays outstanding as a lease for an extended period of time. We like that model and it’s nice to see that that model is going to potentially have some traction in that market.

But a reg change would be welcome. Lots of folks are working hard on that and more game introductions with greater penetration is required for us to have a good impact there.

Operator

Your next question comes from Justin Sebastiano – Morgan Joseph.

Justin Sebastiano – Morgan Joseph

You had said that first quarter earnings guidance you had expected at the lower end or even below the previous guidance range. I just wanted to verify the guidance range that you had given on the last call was $0.30 to $0.35. Is that correct?

Thomas J. Matthews

It is.

Operator

Your next question comes from Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Could you give your strategy heading into G2E this year? Last year you were clearly focused on your SB platform will that change materially going into this year? Are you going to be focused more on the content?

Thomas J. Matthews

It’s too bad that content ever seems to take a back seat because this company is built around games. It’s focus is games and every show has that as its core. But because of the idea of how games are going to be delivered and how the customer experience is going to be expanded due to network implementation, that that seems to kind of be in the background now.

This show where we launched AVP and we launched MLD, you will see a much greater impact from our game development than maybe you noticed in recent shows. That’s being deployed on a smaller footprint in the casino environment. It’s all about how to help the performance of 25 to 100 games through expanded offerings on the game side of the equation. And so even the SB offerings, the strategy will have a much greater games focus than it has in times past.

So I think content will be the star of the show this year.

Operator

Your next question comes from Joseph Greff – J.P. Morgan.

Joseph Greff – J.P. Morgan

You referenced a 30% EBIT margin target. Can you give us a time frame in which you think it is reasonable to get there?

Thomas J. Matthews

I would like to get there through revenue growth. As you know, we’ve been challenged by that ever since our peak domestic shipments in 2004 and although we have diversified our revenues into other markets, not enough to offset what has now cost demand on hardware. Hardware is going to pick up here. Just in the natural course of the cycle we are starting to approach the tipping point of floors getting dated again. There might be a little capex issue that defers some of that activity but I think that you will see unit demand increase here by the end of 2009. That bodes well for some amount of revenue growth for IGT.

But at the same time we’re mindful that if revenues are what they are, given to the maturity of the gaming industry, you know, at one point our floor-wide deployment strategy at CitiCenter as kind of a launch of SB had following it 89 identified new casinos, of which 35 of those casinos were identified as existing IGT systems customers. That landscape has changed. Most of those new casinos either are being completed or have been deferred or cancelled.

And so the result we really have to be focused on is partial floor deployment and so we are. But that also means we have look at cost structure. And as I said, I think if we get to $175.0 million or so run rate, we are going to be pretty close to that 30%, provided that revenues cooperate. But if not, then throughout this period this year we will be continuing to be focused on expenses with the idea that if not with this effort, through subsequent efforts we will get to that 30% margin. So I fully expect that that goal is realized, at the very latest, going into 2010 and be surprised it if takes that long.

Operator

That was the final question.

Thomas J. Matthews

Thank everyone for their time this morning, their interest in IGT and taking time to understand where we are in the business. We had a tough 2008 and we realize that there is an enormous penalty to be paid for having declining EPS on a year-over-year basis and that’s going to be what many remember 2008 by when it comes to us. We feel very comfortable that 2009 will be a year in which we return to growing the earnings per share of this company, return to growing revenues and in fact feel very optimistic about the product outlook of our company. We will highlight that next month at G2E and expect that you will see the results of that continue to build throughout 2009.

So we look forward to talking to you again in January and thanks for your time again today.

Operator

This concludes today’s conference call.

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Source: International Game Technology F4Q08 (Qtr End 09/29/08) Earnings Call Transcript
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