International Game Technology F3Q10 (06/30/2010) Earnings Call Transcript

| About: International Game (IGT)

International Game Technology (NYSE:IGT)

F3Q10 (06/30/2010) Earnings Call

July 27, 2010 5:00 pm ET


Eric Tom - Chief Operating Officer

Patti Hart - Chief Executive Officer, President, Lead Independent Director and Member of Stock Award Committee

Patrick Cavanaugh - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer


Joseph Greff - JP Morgan Chase & Co

Chris Woronka - Deutsche Bank AG

Steven Wieczynski - Stifel, Nicolaus & Co., Inc.

Robin Farley - UBS Investment Bank

Steven Kent - Goldman Sachs Group Inc.


Welcome and thank you for standing by. [Operator Instructions] And now, I'd like to turn the meeting over to Mr. Patrick Cavanaugh, CFO of IGT. Thank you, sir.

Patrick Cavanaugh

All right. Thank you, operator, and good afternoon, everyone. Welcome to IGT's Third Quarter Fiscal 2010 Earnings Call. With me on the call today are Patti Hart, our CEO and President; and Eric Tom, our Chief Operating Officer.

Before we begin, we'd like to remind listeners that our discussion reflects management's views based on marketplace environment as of today, July 27, 2010, includes forward-looking statements, including forecast of future performance and estimates of amounts not yet determinable, the potential for growth of existing and the opening of new markets for our products, play levels for our installed base of reoccurring revenue gain, as well as our future prospects and proposed new products, services, developments or business strategies.

Our future financial condition, results of operations, as well as forward-looking statement are subject to change and to inherent known and unknown risks and uncertainties. We do not intend and undertake no obligation to update our forward-looking statements to reflect future events or circumstances. And you should not assume later in the quarter or the year that the comments we make today are still valid. The actual results may differ materially. Additional information about factors which could potentially impact our financial results is included in today's press release, and our filings with the SEC including our most recent annual report on Form 10-K, Form 8-K dated June 3, 2010, applying the retrospective adoption of accounting standards and our reports on Form 10-Q filed during fiscal 2010.

During this call, we may discuss certain non-GAAP financial measures in our press release and our filings with the SEC, each of which is posted on our website, You will find additional disclosure regarding any non-GAAP measures, including reconciliations of these measures with comparable GAAP measures.

Turning now to our discussion about the business. This afternoon, IGT reported third quarter results for fiscal 2010. Income from continuing operations totaled $95 million or $0.32 per diluted share versus the $62 million and $0.21 per diluted share in the prior-year quarter. The current quarter benefited from certain discrete tax items of $37 million or $0.12 per diluted share, offset by restructuring charges of $3 million and debt refinancing costs of $4 million, collectively $0.01 per diluted share. The favorable discrete tax items recognized in the third quarter of fiscal 2010 primarily related to the IRS audit closure for the fiscal years 2002 through 2005, and these were partially offset by changes in our uncertain tax liabilities. The prior-year quarter included restructuring charges of $3 million and debt refinancing charges of $6 million, collectively $0.02 per diluted share.

Excluding the items mentioned above, third quarter adjusted income from continuing operations was $62 million or $0.21 per diluted share for fiscal 2010 and $67 million or $0.23 per diluted share for fiscal 2009. A list of the items affecting comparability for all periods presented is included in a supplemental reconciliation of adjusted income from continuing operations in our earnings press release that went out this afternoon.

Third quarter net income, including discontinued operations related to the closure of our Japan operation, totaled $92 million or $0.31 per diluted share versus $61 million or $0.21 per diluted share in the same quarter last year.

Our consolidated revenues for the third quarter were $490 million of which 56% was generated from gaming operations and the balance from product sales, compared to $517 million for the same quarter last year. Nine months ended June 30, 2010, consolidated revenues were $1.5 billion compared to $1.6 billion on the same period last year. Consolidated gross profit and operating income for the quarter were $276 million and $120 million, respectively, and $844 million and $320 million, respectively for the nine months ended June 30, 2010.

At the beginning of fiscal 2010, we adopted accounting standards requiring retrospective application of prior periods associated with our convertible debt and the equity classification of non-controlling interest. The retrospective adjustments are outlined in the supplemental schedule at the back of our press release. The new accounting standards for convertible debt resulted in reduced diluted EPS of $0.01 for the current quarter and $0.02 in the prior-year quarter.

Moving on to Gaming Operations. Revenue were $277 million in the current quarter, which was down 1% sequentially and down 4% year-over-year. Gross margins were 58% for the quarter versus 62% in the prior-year quarter, primarily due to increased jackpots, hence resulting from interest rate changes.

Interest rate change on jackpot liabilities increased jackpot expense by $6 million in this year's third quarter and decreased jackpot expense by $3 million in the prior-year quarter. Jackpot liabilities are recorded on the books at present value. Until a jackpot is paid out as a lump sum or annuity versus to fund the longer-term payment stream, changes in interest rates affect this present value calculation. For example, decrease in interest rates increase the present value of the jackpot liability, which increases the liability on the balance sheet and also increase the jackpot expense and Game Operations margin. The opposite effect occurs when there are increases in interest rates. We expect fourth quarter Game Ops gross margins to trend within a range of approximately 58% to 61%.

We earned an average of $51.68 in revenue per unit per day, which is up 1% sequentially and up from $51.47 in last year's quarter. This is the second consecutive quarter that revenue per unit per day is up on a sequential basis while not up a large amount it's starting to show some stability.

We encouraged by the recent uptick as sign of innovation and a testament of the quality of our latest Game Ops games. This blended yield of $51.68 is an average of the various components of our broad and diverse installed based comprised of our MegaJackpots, CDS Class II and lease ops units, all of which served distinct markets and have unique yield characteristics.

Our Game Ops yields range from $10 to $15 per day on some of our lower yielding units and in international units to a more than $100 per day on some of our MegaJackpot units. During our fiscal third quarter, one additional property in Alabama ceased operations, or in the remaining non-Native American property opened, which has 1,800 IGT electronic charitable bingo terminals operable. We are currently recognizing revenue on a cash basis only due to the uncertainty in the market.

IGT's install base ended the third quarter at 58,900 units, up 100 units over the prior-sequential quarter and down 2,200 units compared to the prior-year quarter. North American decreases over the prior year largely attributable to regulatory issues in Alabama were partially offset by increases in international markets. Approximately 83% of our install base is comprised of variable fee games, which are on a percentage of a machine play levels rather than a fixed daily fee.

Moving onto product sales. Product sales totaled $213 million for the quarter compared to $231 million in the prior year. Both, we shipped 9,000 machines during the quarter, down from prior year shipments of 12,600.

Non-machine revenues comprised of gaming system, game theme conversions, tables, parts, and intellectual property fees came in at $91 million for the quarter and accounted for 43% of total product sales for the quarter, compared to $81 million and 35% of total product sales in the prior-year quarter.

Product sales gross margins were 54% for the quarter, up 300 basis points in the prior-year quarter, primarily due to reduced material cost and an increased mix of higher margin non-machine products. For a reconciliation of units shipped to equivalent units recognized, please see our earnings release. Units shipped for the current periods reflect all units shipped to customers, which include units for which revenues have been deferred. Equivalent units recognized represent the units recognized in revenues under Generally Accepted Accounting Principles.

Now breaking down product sales domestic versus international. Domestic product sales revenue totaled $124 million on volume of 4,500 units recognized for the current quarter compared with $148 million and 6,700 units recognized in the prior-year quarter.

Domestic replacement units shipped totaled 3,200, up 900 units from the prior year and down 900 units sequentially. The sequential decline was driven by lower replacements in Canada, partially offset by higher sales in Washington. Domestic new and expansion shipments totaled 900 units in the quarter, up 100 sequentially and down 3,600 from the prior-year quarter due to fewer new openings.

Respective adoption of revenue recognition accounting standards related to certain software-enabled products and multi-element arrangements as of the beginning of fiscal 2010, resulted in $8 million of consolidated revenues in the current quarter, which would have been recognized in different periods under the prior guidance.

Domestic non-machine revenue totaled $61 million in the quarter, up from $52 million in the prior-year quarter, primarily due to the DynamiX promotional conversion and higher systems-related revenue. Domestic ASPs were 14,100 for the third quarter compared to 14,400 in the prior-year quarter. And domestic ARPU computed on equivalent-units-recognized basis was 27,600 for the third quarter compared to 22,100 in the prior year. ASP decline was due to the DynamiX promotion, which defers a portion of the sales price to the related conversion kits. When a customer takes delivery of these conversion kits, the associated revenue is recognized and shows up non-machine revenue. The ARPU increase was due to increased non-machine revenue. We shipped 2,200 MLD units or 55% of total North American shipments in the third quarter compared to 900 units or 13% of total North American shipments in the prior-year quarter. Sales and machines utilizing our AVP technology comprised 92% of total North American machines shipped during the third quarter, a trend we expect to continue as our legacy-for-sale products are phased out.

International product sales revenue totaled $89 million on volume of 5,400 units recognized for the current quarter compared to $83 million and 5,500 units recognized from the prior-year quarter. Our international markets benefited from favorable foreign currency exchange, as well as the opening of Marina Bay Sands in Singapore and improved sales in Mexico. International non-machine sales were $30 million in the third quarter, flat compared to the prior-year quarter. International ASP was 10,900 for the third quarter compared to 9,600 in the prior-year quarter. And international ARPU computed on an equivalent-units-recognized basis in the third quarter was 16,400, up 9% over the prior quarter.

Both international ASP and ARPU increases were primarily due to favorable foreign currency exchange as well as better product and the geographic mix. Total product sales gross margins for the quarter were 54%, up 300 basis points from the prior-year quarter, primarily due to reduced material cost and increased mix of higher margin non-machine products. We expect product sales margins in the fourth quarter to trend within a range of approximately 50% to 52% depending on product sales mix.

Now moving on to OpEx. Quarter operating expenses decreased 8% to $156 million compared to $169 million on the prior-year quarter, primarily due to the cost-reduction efforts and lower professional service fees.

We continue to move towards our goal of previously announced $200 million of annual cost savings when compared to the fourth quarter of 2008. We feel that we are well on track to achieve our cost-reduction goal as we exit this fiscal year.

Third quarter SG&A declined $13 million or 13% from the prior quarter to $82 million, primarily result of our continued cost-control efforts. Professional fees were also down due to debt refinancing costs of $1.8 million included in the prior quarter. We expect a quarterly SG&A run rate of $85 million to $90 million on the fourth quarter. Bad debt provisions totaled $1 million for the quarter, flat compared to the prior quarter. R&D expense totaled $52 million for the quarter, flat compared to the prior quarter. We expect the quarterly R&D run rate in the low $50 million area.

Depreciation and amortization within operating expenses totaled $19 million for the quarter, relatively flat to the prior-year quarter. Total depreciation and amortization, inclusive of that is included in cost of Game Ops, was $59 million for the quarter, down from $64 million in the prior year. The decline in total depreciation and amortization was primarily due to lower depreciation in our domestic MegaJackpot and CDS operations. We expect depreciation and amortization to be flat in the fourth quarter compared to this quarter.

Other income and expense in the third quarter was a net expense to $24 million compared to $26 million in the prior quarter. The decline was largely attributable to foreign currency gains and reduced interest expense on lower borrowings. Third quarter interest expense included debt refinancing charges of $4 million due to a $300 million reduction in the total size of our debt domestic credit facility in the current year and $4 million related to early breakage fees on our line of credit in the prior year.

Additional convertible debt amortization required under accounting guidance adopted retrospectively at the beginning of this fiscal year, increased interest expense by $7 million in the current quarter and $9 million in the prior-year quarter. For the full year, we expect incremental non-cash interest of approximately $30 million, $19 million after tax or $0.06 per diluted share for this fiscal year and approximately $35 million and $22 million after tax or $0.08 per diluted share for fiscal 2009 as restated, including repurchased gains of $5 million.

Our tax rate was 2% in the third quarter versus 38% in the prior-year quarter. The tax rate during the quarter was impacted by the previously mentioned favorable discrete tax items related to the closure of IRS audits for the years 2002 through 2005, partially offset by changes in uncertain tax liabilities. The current quarter tax rate, excluding discrete items was approximately 39%.

Going forward, we expect our quarterly tax rate to trend at approximately 37% to 39% before discrete items. However, we may experience volatility on our quarterly tax rate due to the impact of discrete items.

Moving on to the balance sheet. Cash equivalents and short-term investments inclusive of restricted amounts, totaled $252 million at June 30 compared to $247 million at September 30, 2009. Contractual debt obligations totaled $1.9 billion with $1.2 billion of available capacity on our $1.5 billion credit facility as of June 30. It's important to note that the adoption of new accounting rules for convertible debt mentioned earlier decreased our book debt by approximately $131 million at June 30 and $155 million at September 30, 2009. This amount is the unamortized discount related to the implied value of the equity options in our converts, which was recorded in equity.

For the purpose of bank covenants, we continue to use contractual debt obligations, which totaled $1.9 billion at June 30, a decrease of $242 million compared to September 30, 2009. Our bank leverage ratio at June 30 was 2.5x, a decrease of a half a turn, down from 3x at September 30, 2009. We issued $300 million of 5.5% notes due June 2020 during the quarter. The net proceeds were used to pay down a portion of our domestic credit facility, which currently has an outstanding balance of $270 million, a decrease of $400 million from prior-sequential quarter. In conjunction with this note offering, we reduced the total commitment on our domestic line of credit from $1.8 billion to $1.5 billion.

Our 3 1/4% convertible notes and warrants were excluded from diluted shares outstanding for the period ended June 30, 2010, because of conversion price and the exercise price exceeded the average market price of our common stock.

On the balance sheet, we made a lot of progress with our working capital ratios and conversion of working capital and the free cash flow. Working capital totaled $609 million at June 30 and at September 30, 2009, average days sales outstanding, excluding receivables from our notes and contracts and Japan operations, was 50 days, down from 58 days as of September 30, 2009. Inventory turns excluding Japan operations averaged 3.8x, up from 2.9x as of September 30, 2009.

For the nine months ended June 30, 2010, IGT generated $424 million in cash flow from operations compared to $354 million for the first nine months of last year. During the quarter, we saw a continued improvement of working capital efficiencies such as reduced inventory balance, the lowest it's been in the 41 quarters. The nine months ended June 30, 2010, IGT generated $192 million in free cash flow compared to $75 million for the first nine months last year. All of this free cash flow was used to pay down debt.

Capital expenditures totaled $61 million for the quarter compared to $64 million in the prior-sequential quarter due to lower PP&E. CapEx is expected to trend in the quarterly range of $60 million to $65 million for the fourth quarter, although we continue to come in near the lower end of the range as we more proactively manage our CapEx as part of our efficiency and cost reduction efforts.

That concludes my prepared remarks regarding IGT's third quarter. Thanks for your time and attention. I will now turn the call over to Patti for her comments.

Patti Hart

Thank you, Pat, and good afternoon, everyone. Thank you very much for taking the time to join us as we discuss our fiscal third quarter. Our customers continue to spend capital at a conservative pace in an uncertain economy, but we cannot avoid the impact of the economic conditions affecting our customers around the globe. We can focus our efforts on making IGT stronger and more nimble ahead of an improvement in the macro environment. We continue to focus on improving our balance sheet. As Pat mentioned, we recently refinanced $300 million of debt through the sale of 5 1/2% notes that are due in 2020. The rate is 200 basis points less than the notes we priced in June of 2009. Additionally, our contractual debt obligations declined by $100 million sequentially. Our focus on the generation of free cash flow remains our highest priority. We are aggressively managing our cost structure as evidenced by a decline in operating expense of 8% and a decline in SG&A of 13% over the prior-year quarter.

We are addressing the need for improved efficiency in the application of our research and development resources. We are unifying our platforms and processes across the studio structure, giving us increased leverage from our development tools. This standardization is allowing us to more rapidly gain productivity improvements and increase the quality of our game content.

In the Systems business, we are capitalizing on our investment in server-based gaming and the increased quality of Advantage by focusing more of our engineering efforts on applications and content. The number of server-based installations now numbers 14 with four pending installations and numerous others in various stages of contract negotiation. Our focus on open standards and technologies will allow us to rapidly add customer-centric functionality to our growing server-based customers set.

We have significantly reduced the complexity of our hardware platform and increased the standardization on the AVP platform on a global basis providing further economies of scale. We continue to deliver our latest innovative products to markets around the world. During the quarter, we announced the installation of our sbX Tier One in France, Finland and Italy, our M-P Roulette Evolution in Switzerland and an extension on our contract with the University of Iceland Lottery to provide MLD video slots and Casinolink, as well as the implementation of EasyPay. Our WagerWorks online and mobile subsidiary was officially crowned Slot Provider of the Year at the inaugural EGR b2b Supplier Awards in London.

Joining us today is Eric Tom, our recently appointed Chief Operating Officer, who will share with you a bit more about our strategic product initiatives and give you a broader overview of our customer-facing activities. Eric?

Eric Tom

Thank you, Patti. I'm pleased to talk about this quarter's activity in both games and systems. But first, I wanted to comment on my new responsibilities as Chief Operating Officer. In my new role, my responsibilities include: All our land-based products, MegaJackpots for sale and systems; and also include North American sales, marketing services and soon, manufacturing operations and sales outside of North America. I'll continue to focus on building a market-driven organization with a customer-first perspective and improving the operational efficiency of the company.

Here are some highlights regarding the product performance for the quarter. In Gaming Operations, overall yields were $51.68, an improvement of 1% sequentially, reflecting a slight increase in play levels. Our stand-alone MegaJackpot yields improved 2% sequentially. Sex and the City, now with more than 1,300 units installed since its release, continues to perform and is earning up to $1,090 per day for some of our customers. Additionally, our latest generation of game titles, Amazing Race, Top Dollar and Super Nova Blast now have 790, 391 and 362 units deployed, respectively. As of June 30, our backlog for these four titles that I just mentioned stood at 1,202 games, and our total backlog for MegaJackpots stood at 3,397 games.

In our For Sale business, we have developed and released 104 game titles to the first three quarters of this year, compared to 56 titles during the same period in 2009. Some of the recently-released titles include the Cats MultiPLAY, Boozing [ph], the industry's first 3D video slot, Queen Isabella, Lion's Heart [ph] and Jumpin' Jungle. We expect to complete development of another 30 to 40 titles in the fourth quarter of this fiscal year. Our very successful DynamiX package, which bundled one new AVP slot machine with two 8960 conversion kits allow the customer to refresh three machines concurrently. The promotion ended on June 30. Under this customer-focused program, we sold 6,300 units.

Other highlights for the third quarter include: We're excited about the recently-announced agreement with Cosmopolitan to provide them with a multi-product and system solutions, including sbX, our server-based gaming solution, a majority of their games plus the entire suite of IGT Advantage system products. The casino floor will feature IGT's GSA compliant server-based network, which incorporates the award-winning, player-focused Service Window, sbX Floor Manager, Media Manager and access to IGT's game library. Our success with Cosmopolitan is a result of our efforts to leverage the value of our comprehensive product and systems portfolio of for sale games, MegaJackpot games and systems infrastructure and applications.

Our account managers and strategic account managers are trained across the entire portfolio and they're supported by subject matter experts in the field. This allows us to have a more elevated discussion at a much more strategic level that includes different disciplines within our customers' organizations. The strategic approach, in place since September of last year, allows us to focus on specific areas of need for our customers while leveraging the breadth of our product portfolio.

During the third quarter, we announced several key Tier One successes including the installation at the Mohawk Casino in New York, Casino d'Evian in France, Casino Helsinki in Finland, Casino di Venezia in Italy. Additionally, we announced our first field trial location of sbX Floor Manager on a non-IGT system at the Orleans Hotel and Casino in Las Vegas. Our sbX Floor Manager provides The Orleans unlimited access to our expansive game library of nearly 300 game themes with new themes added each month.

In North America as of June 30, we are in varying contract stages with three sbX opportunities and 10 Tier One opportunities. Additionally, we are in varying contract stages with 10 Tier One international opportunities. Please understand that these are only opportunities, and there's no guarantee that we'll close any of these opportunities.

In our Traditional Systems business, in the third quarter, we closed five new Advantage customers, of which three were replacements of our competitors' systems. And as of June 30, we are in varying contract stages with seven new Advantage customers. Again, there is no guarantee we will close any of these opportunities.

I'm excited to be IGT's new Chief Operating Officer and as we move forward, we will continue to focus on customer-centric orientation in game and system development while leveraging our operational resources in an effective and efficient manner.

With that, I'll turn it back to Patti to speak about our broader corporate strategy and our outlook for the remainder of 2010. Patti?

Patti Hart

Thanks very much, Eric. We are encouraged by the activity to expand gaming, both domestically and internationally, and I thought I'd spend a few minutes just giving you an update on our views.

First, in Ohio, the previously delayed VLT program for the state's seven racetracks has been revived with the official withdrawal of the measure from the 2010 general election ballot. And last week, the Ohio Lottery Commission voted unanimously on three items that would withdraw old rules on VLT and install new rules and seek the court judgment affirming the Commission's authority to install slots at racetracks.

In Illinois, the implementation of the VLT program is proceeding with the awarding of the central monitoring system contract, the adoption of administrative rules and the licensing process has been initiated. The City of Chicago, which represents a potential market for up to 15,000 machines, is still waiting to pass the necessary city council resolution to opt-in to the program. Initial shipments for Illinois are projected for early calendar 2011.

In Massachusetts, both the State Senate and House have passed their own versions of the gaming bill. The bills are currently in a conference committee made up of members from both the House and Senate who are working towards a compromised measure. However, they're working against a July 31 deadline for their summer adjournment. The prospects for a gaming bill remains extremely high, and the governor continues to indicate his support. We are closely monitoring the legalization of gaming in both Kentucky and New Hampshire.

In Canada, the VLT replacement process continues to move slowly, and we expect the majority of the games to come online in 2012. Of the 34,000 games in Canada, we estimate that approximately 20,000 to 25,000 could be replaced over the next two to three years.

In Italy, all 10 concessionaires have paid half of the license fee and therefore, all 55,000 license have been taken. The approval process has delayed the rollout and today, only Lottomatica has received approval and has opened their first site in Rome. We expect approval for one of our installations in September and to have machines operating in the first quarter of 2011 and approval for a subsequent shipment in early 2011.

In Brazil, the parliament did not vote for the new bingo legislation in advance of their leave due to their upcoming October election. Depending upon the outcome of the election, we could see the proposal resurface as early as next year.

In Greece, we expect that within one month, a proposal for VLT legislation will be submitted and with the consultation process, EC and parliament approval, we expect final legislation by the end of 2010 with a potential operational date of late 2011. The market potential in Greece is approximately 50,000 VLTs, which will require an upfront license fee of eur 10,000 apiece to be paid in two installments. The expectation is that this market will be on a bit of a fast track due to the economic stress in the country.

In the quarter, we also made progress with pending litigation which never happens quickly or easily. Concerning the pending shareholder actions, the four initial shareholder derivative suits that were filed against the company in 2009 were recently dismissed with leave to amend from the Federal District court in Nevada. In another case, our motion for summary judgment was recently granted in a suit filed by a competitor in 2006, which alleged infringement of one of its game method patents.

We continue to build and strengthen our senior management team. Eric spoke about his new responsibilities as the Chief Operating Officer; and Chris Satchell, our Chief Technology Officer, has expanded his responsibilities to include the leadership of Research and Development. As our CTO and Executive Vice President of Research and Development, Chris will lead the company's effort to continue the development of groundbreaking and innovative products for the gaming industry.

We announced in the quarter the retirement from IGT of Tony Ciorciari who is currently in charge of Global Operations; and Paulus Karskens, the President of our International Organization. Over the next six months, we will work with Tony and Paulus to transition their work to the capable organizations they'll leave behind. We also announced the appointment of Vince Sadusky, a seasoned media executive to our Board of Director.

We remain laser focused on creating long-term value for all of our shareholders by continuing as a profitable company that generates significant cash flows. Our objective is to provide superior financial results through disciplined strategic actions. And I want to thank all of you for your continued support.

As I mentioned, we are cautiously optimistic about the short-term pending activity of operators, but we will make strides within our company towards being as lean and mean as possible, heading into an inevitable and sustainable increase in customer spending levels. There are a few factors that might impact our fourth quarter results such as the continued lack of visibility around replacement demand, revenue recognition risks associated with a few significant transactions and the impact of interest rates on our Gaming Operations margin.

As a result of all of these factors, our guidance for 2010 has moved to a range of $0.82 to $0.85 in earnings per diluted share. As always, our guidance excludes one-time items. Our guidance also assumes no dilution impact from our convertible notes.

So with that, we'll open the call for questions.

Question-and-Answer Session


[Operator Instructions] And our first question comes from Chris Woronka with Deutsche Bank.

Chris Woronka - Deutsche Bank AG

Pat or Patti, could you guys talk a little bit about the sustainability of cost cuts going forward? When you see the top line come back to the point where you're a little bit more confident, how much of these cuts are permanent? How many could come back in a different environment?

Patrick Cavanaugh

I'll go ahead and take it, Patti. I think, Chris, for the most part, most of them are sustainable with the exception of any of the variable compensation-related things that are triggered by higher levels of operating income and revenue. But those will more than be faded in the number. But I think, otherwise, most everything that we've taken out of the cost structure, I think, is pretty sustainable. Now up in the margin, the variable component there would be those people on the manufacturing areas that would come back as volumes would pick up. But again, I think that would be more than faded in the number.


Our next question comes from Joe Greff with JPMorgan.

Joseph Greff - JP Morgan Chase & Co

Pat, you touched on this very briefly in your earlier comments, but can you just go -- and looking back at the fiscal 3Q and looking at net domestic non-machine sales, that was the highest result since the December '08 quarter. Can you further explain or clarify what drove that and if there's sustainability for that type of performance going forward?

Patrick Cavanaugh

Sure. I think two things primarily drove it, Joe. One were those free conversions that got allocated away from -- remember, the question last quarter on ASPs, the reason they were lower was because we had to allocate the fair value of the conversions that were given up. Now what you're seeing is customers starting to take delivery of those conversions, and so that deferred revenues are on back up. The balance sheet now probably continued for at least through Q4, I would assume. The other piece and they were about equal, I think, in weight, was improved largely Advantage system installations during the quarter and some application and bonuses and things we delivered. That's the one that could be a little bit more volatile quarter-to-quarter because of rev rec rules.

Patti Hart

Yes. I would just add to that, Joe. I just think that what we expected to happen when we rolled out the DynamiX program is exactly what happened, which is we had about, sequentially 1,000-unit increase in conversions this quarter from the previous quarter. So what we thought would happen, happened, which is we stabilized the base of the 8,960 machines and we sold conversions into that market. And that was a significant difference in the product sales, and we're still waiting for the rest of those from the promotion to make their way through. So I think you will see it for a couple of more quarters. But it was a significant contributor in the quarter.

Joseph Greff - JP Morgan Chase & Co

And then I thought Eric Tom's comments regarding the backlog was interesting. Given that you have pretty good visibility on backlogs, how do you see that influence the net growth within the installed base? So for example, if you have just under 3,400 in total backlog, should we think of it as a two-for-one replacement of existing IGT games on force?

Eric Tom

Joe, I think that'd be aggressive. Our initial objective is to put the higher performing games that we're developing into the market to shore up games that have been out in the floor for quite some time and maybe not earning as much as they should. So I would think of much of our efforts currently to shore up our existing base.

Joseph Greff - JP Morgan Chase & Co

So it's more yield related than installed base goes through [ph]?

Eric Tom

To the extent the near-performing games that we do have a sense that they are perform at a higher rate than the games we're taking off, yes.

Joseph Greff - JP Morgan Chase & Co

And then I have a question to Pat Cavanaugh. I think you'll probably get a lot after this call, but can you help explain or clarify what your 4Q EPS is in relation to what you think the Q1 should be [indiscernible] in that new guidance?

Patrick Cavanaugh

Sure. I think the entire range, Joe, is predicated on the fact that it is their line of sight essentially do a number similar to this quarter? Yes, but that number has a lot of risk in it from a rev rec standpoint. And then as you can see, visibility to replacement demand continues to be very, very limited. And so that's probably the combination of those two things, I think, are the big wildcards.

Joseph Greff - JP Morgan Chase & Co

So the $0.82 to $0.85 -- I'm basically just subtracting the $0.66 in adjusted diluted per share that you have in the press release here for the nine months ending June 30?

Patrick Cavanaugh

That's correct.


And our next question comes from Steven Kent with Goldman Sachs.

Steven Kent - Goldman Sachs Group Inc.

Eric or Patti, maybe can you just talk about what your customers are saying? You've mentioned now a couple of times that things -- you don't have a lot of clarity on what customers are purchasing or sort of the environment out there. What are they waiting for? For revenues to increase at the local level? For capital budgets to increase? What are the issues that they talk about?

Eric Tom

Patti, you want to take that? I can add some...

Patti Hart

I'll go ahead and go first and then you add. I mean you're in the front of -- but we just had our leader's conference this past week, and Eric spent a lot of time with 400 representatives of our customers so he's probably a little more current than I am. But I think it's a little bit of everything, and I think it depends on who it is. In some cases, they are waiting for their own financial performance to make its way up. To the extent, they're in a destination location, they're waiting for occupancy rates to stabilize, to increase and then stabilize a bit and for a lot of the vulnerability to make its way out of their own business. Access to capital and the cost of their capital for some customers is an issue, for others, it's not. So I think it really depends on who the customer is, but I would say generally, they're waiting for the malaise to lift in the travel and leisure industry, in general, before they really are comfortable spending ahead of the cycle. Because right now, they all feel like they would be spending ahead of the cycle. So that's kind of my view from my conversations with them. Eric, I would ask you to add your thoughts.

Eric Tom

Yes, I think Patti, exactly all those things you mentioned. The only color I'd add to what you said is I think the market -- our customer base is very beaten, having gone through to two and a half years of uncertainty. And so, I believe they're being very cautious about getting ahead of themselves. And the other piece is that's affecting their investment and their infrastructure. They realize that they've got aging floors, but all of them seem to be -- I mean not all of them, but a good number of them seem to be looking at the other competitor to see who's going to go first, each one being pretty cautious. I think the ones that I'd spoken to that have strong balance sheets are talking actively, but still in the planning stages without any commitments. Those without strong balance sheets tend to be acquisitive, but not necessarily very fruitful discussions.

Steven Kent - Goldman Sachs Group Inc.

And just a follow up, does that imply that there will be a lag so trends will come back and then it might be six months to 12 months before they start to buy again? Maybe if you can think about your history? And then just separately, just as housekeeping, is Sex and the City and the Amazing Race and some of those other games you mentioned, Eric, are those replacing Wheel of Fortune? Is that what's going on out there?

Eric Tom

To your first question, difficult for me to predict what kind of buying patterns will occur. Principally because most of my conversations have a certain level of uncertainty on their part and certainly on the very front end so therefore, it's very difficult for them to comment what they do in subsequent cycles. Relative to Sex and the City, no. Actually, we are not replacing our WAP games. We'll be replacing really our stand-alone MegaJackpot games with our Sex and the City installs.


Our next question comes from Robin Farley with UBS.

Robin Farley - UBS Investment Bank

First, it seems like your Q4 guidance is -- and this is just [indiscernible] maybe counting onetime factors in there. But it looks like you're implying kind of a $0.16 to $0.19 a quarter, and I know you said -- because I just wanted to confirm that. And then you said that you saw there was risk to the -- that a $0.21 quarter is possible, but you saw risks. I guess given that all the last three quarters, you've been above the $0.20 range, can you talk about what is the concern that we should think that the fourth quarter will be somehow, even the last nine months -- is it replacement sales? Is it new unit sales? In other words, what would we expect to see falling off sequentially for earnings to land in that range?

Patrick Cavanaugh

Sure, Robin, I'll comment on that. Probably the things -- well, in the new area, you've got Cosmopolitan, obviously, which there's a lot of risk around whether or not that revenue could be realized in Q4 just given the timing of when that property opens, and the revenue recognition given that we're spying both the system and the boxes. And then there's still new type to ARIA that is contemplated in the quarter, but is predicated on delivery of some additional software, which will be tight to get in by the end of the quarter. And then I think the risk is just the continued lack of visibility around replacements. Then follow up to Patti and Eric's comments about -- our customers have clearly shown over the last couple of years, that they're managing their capital budgets over much shorter increments than the time they have historically because they're looking for, I believe, first, stability in their business before they're going to let go. And then there's still some incremental risk in interest rates. We saw treasuries drop below prime for the first time in recent memory. And of course, we always use the higher rate to value our jackpot liabilities. And so, if agencies should compress, you still got probably 50 basis points of spread there between them. So those are kind of at the high end where the biggest risks are in terms of the magnitude.

Patti Hart

Yes. I mean what I would add to that, Robin, is if you look at the non-box part of our business and how it is growing in its participation in the overall revenue story, and it just was -- it's more difficult, I guess I would say, to predict the timing on the acceptance of the system. And it's just part of being in that Systems business. But the non-box products revenue for the quarter was such a significant contributor for us, which has been an objective of IGT for some time, and we feel like we're accomplishing the objective of letting our Systems business play a more robust role. It's very high-margin business for us and it drives, overtime, boxes, but it is less predictable from a revenue-recognition prospective. So the two projects, large projects on some of the custom software deliverables to ARIA and then the Cosmo project, they're going to be tough for us to predict getting them in the quarter.

Robin Farley - UBS Investment Bank

And then also can you give a little color on what happened to replacement since the end of the DynamiX promotion at the end of June? So basically, how sales have gone in July since that promotion stopped? And whether you think that is a promotion that you would need to bring back to maintain replacement sales? Just some color on the last few weeks I guess without it?

Patrick Cavanaugh

Sure, I'll let comment first, Robin, then let Eric offer his thoughts as well. We, like you, can't really assess total demand in the market until all of our competitors have reported their results. But the general sense that we get is that, and you saw it in the numbers, that there was just less replacement demand and incentives are provided or not in Q3 versus Q2. And in Q2, we had the help of a big replacement order in Canada, which those are government customers and their buying patterns tend to be a little bit different than the commercial casino operators.

Patti Hart

What I would add to it is I think that promotions do just run their course. And there's a certain point in time at which the market that is going to take, that has enough of an 8960 base to really find it compelling to purchase a new box in order to get upgrade, just it becomes de minimis at some point. And so we've realized we're not at the point where it is totally ineffective, but we think it's time to pull that back and now focus our customer base on moving to the AVP platform overtime.

Robin Farley - UBS Investment Bank

Just a very quick clarification on your comments about Italy and you referred to early 2011. Was that a fiscal or a calendar reference?

Patti Hart

It was a calendar reference.

Robin Farley - UBS Investment Bank

So in other words, it would be the March quarter?

Patti Hart

Yes, for us.


And your next question comes from Steve Wieczynski with Stifel, Nicolaus.

Steven Wieczynski - Stifel, Nicolaus & Co., Inc.

Pat, one question for you. I guess I'm a little surprised when I look at the margin on the product sales side. You basically are saying 50% to 52% for the fourth quarter, but I'm assuming that non-machine sales over the next couple quarters are going to stay pretty close to equal as machine sales. So I'd assume that the margin will be a little bit higher?

Patrick Cavanaugh

That's possible. So again, that's kind of to our earlier comments, there's risk. So again, could we realize margins above 52%? Most definitely, but I think it's heavily predicated on things that are more out of our control in terms of predictability on rev rec relative to Systems. And it's more of visibility around one quarter versus the next versus it's not an issue of it's going to come in three quarters from now. It's really more of just about will it make it into the quarter versus the subsequent quarter.

Steven Wieczynski - Stifel, Nicolaus & Co., Inc.

And is there anyway you could quantify the 300 basis points year-over-year change between -- you talked about reduced material cost versus the higher non-machine product sales, is there anyway to quantify how much of that came from reduced material costs?

Eric Tom

I haven't looked at it specifically, but probably at least half and half, half-produced materials costs and half due to the higher-margin, non-box stuff.

Steven Wieczynski - Stifel, Nicolaus & Co., Inc.

And then the 900 new units you sold domestically, can you kind of talk about where they came from? Was there one market where they came from?

Patrick Cavanaugh

I think it was a small number of locations. About half of it came from three properties. I mean it's a small number as you might imagine year-over-year. We had quite a few more last year.


This ends the question-and-answer portion of our call today.

Patti Hart

Great. Well, thank you very much. Thank you for your time. Thank you for your questions. Thank you for your continued interest in IGT. We look forward to chatting with you in the future. Goodbye.


This concludes today's conference. You may disconnect at this time. Thank you.

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