Shuffle Master F4Q07 (Qtr End 10/31/07) Earnings Call Transcript

Jan.10.08 | About: SHFL entertainment, (SHFL)

Shuffle Master, Inc. (NASDAQ:SHFL)

F4Q07 Earnings Call

January 10, 2008 5:00 pm ET

Executives

Jerome R. Smith - Senior Vice President and General Counsel

Mark L. Yoseloff - Chairman of the Board, Chief ExecutiveOfficer

Paul C. Meyer - President, Acting Chief Financial Officer,Chief Operating Officer, Secretary

Analysts

Joe Greff - Bear Stearns

Steven Wieczynski - Stifel Nicolaus

Joanie Jensen - McMahon Securities

Ryan Worst - Brean Murray Carret

Bill Lerner - Deutsche Bank Securities

Ralph Schackart - William Blair

Operator

Good afternoon, ladies and gentlemen, and welcome to theShuffle Master Gaming fourth quarter and year-end earnings conference call.(Operator Instructions) It is now my pleasure to introduce your host, Mr. JerrySmith, Senior Vice President and General Counsel of Shuffle Master Gaming.Thank you. You may begin.

Jerome R. Smith

Thank you. Good afternoon. I am Jerry Smith, Senior VicePresident and General Counsel of Shuffle Master. With me today are MarkYoseloff, Chairman of the Board and Chief Executive Officer of Shuffle Master;and Paul Meyer, our Chief Operating Officer, President, and Acting ChiefFinancial Officer.

Today’s conference call is being simultaneously webcastthroughout our website and will also be archived for the next 30 days.

During today’s call, various remarks we make about futureexpectations, plans, and prospects for the company constitute forward-lookingstatements for purposes of the Safe Harbor provisions under the PrivateSecurities Litigation Reform Act of 1995. Actual results may differ materiallyfrom these expectations.

We will also be discussing certain financial measures, suchas adjusted EBITDA, which represents a non-GAAP financial measure. Theimportance of this measure to investors, as well as reconciliation to the mostdirectly comparable GAAP measures, can be found in our prior public filings aswell as in today’s press release, which was issued shortly before thisconference call announcing our fourth quarter and fiscal year 2007 results.

Now I will turn the call over to our CEO, Mark Yoseloff.

Mark L. Yoseloff

Thanks, Jerry. Fiscal 2007 was a challenging year forShuffle Master. It was a year in which, although we hit record revenues, EBITDAand earnings per share were impacted by a number of factors. At the same time,fiscal 2007 was an important transitional year for the company as managementaccomplished a number of goals that it considered necessary for sustainablefuture revenue and earnings growth.

The three factors which had the greatest impact on fiscal2007 results are: one, the reemphasis of leasing rather than selling product;two, one-time non-recurring charges related to the integration of Stargames;and three, the impact of foreign exchange losses related to the weakening U.S.dollar.

The factor which had the greatest impact on fiscal 2007 wasmanagement’s decision to reemphasize leasing versus selling of products,particularly in North America. Although this is clearly desirable from along-term strategic perspective, the short-term impact was a substantialreduction in earnings.

Compared to fiscal 2006, utility product sales were down$10.5 million and proprietary table game sales were down $7.1 million. At thesame time, utility product recurring revenue was up $2.2 million andproprietary game recurring revenue was up $1.4 million. The net result of allof this was an earnings per share decrease of approximately $0.21.

Looking forward and annualizing fourth quarter results,utility product recurring revenue at the end of fiscal 2007 on an annualizedbasis was $32.5 million, compared to $28.9 million at the end of fiscal 2006.

Proprietary game recurring revenue at the end of fiscal 2007on an annualized basis was $28.6 million compared to $22.9 million at the endof fiscal 2006.

Increases in recurring revenue will still not completelyoffset reduced sales in fiscal 2008. However, management believes that if wecontinue to grow recurring revenue in fiscal 2008 as we did in fiscal 2007 thenby fiscal 2009 we should have substantially if not completely overcome thisreduction in earnings.

One-time, non-recurring charges related to the integrationof Stargames included inventory adjustments, payments of minimum royaltyshortfalls due to Williams Gaming, and several other miscellaneous itemstotaling $5.5 million with an earnings per share impact of approximately $0.11.

I am pleased to report that although it took longer than weanticipated, this integration is now complete. We have carefully reviewed thebalance sheet and believe that at this point, there are no additional potentialareas of concern.

Also, we have new presidents in Sydney and Macau, and theCFO who we transferred from Las Vegas to Sydney will complete her first year ofservice at Stargames in April. Furthermore, and again, although it has takenlonger than we originally anticipated, our Stargames acquisition is expected tobe accretive to both EBITDA and earnings for fiscal 2008 and beyond.

Finally, fiscal 2007 was impacted by the weakening U.S.dollar, particularly compared to the Euro and Australian dollar. These costsamounted to $3.1 million in fiscal 2007. This equates to about $0.06 per share.Fiscal 2008 will also be impacted by continued weakness of the dollar, althougheconomists predict that the dollar should start to stabilize in late 2008 andwe are taking steps to at least partially mitigate this issue in the mean time.

I would like to now turn the call over to Paul for a moredetailed analysis of the numbers.

Paul C. Meyer

Thanks, Mark. Total revenue for the year increased by 10%from $163 million to $179 million, while Q4 revenue increased by 13% from $46million to $52 million. Revenue for both the quarter and year were records.

Revenue in the electronic gaming machine and electronictable system product segments increased for both the quarter and full year ascompared to the prior periods. Proprietary table gaming utility product revenuedecreased for both the full year and quarter as a result of a reduction insales and conversions consistent with our renewed emphasis on leasing. Tablegame lifetime license sale revenue decreased by $7.1 million and $2.5 millionfor the full year and quarter respectively, while utility product salesdeclined by $10.5 million and $3.3 million for the full year and quarterrespectively.

Of particular note is the level of recurring revenue whichset both full year and quarterly records in all product segments excludingEGMs. This trend is also consistent with the emphasis on recurring revenue.Recurring revenue increased to 30% of total revenue in Q4, compared to 27% inthe year-ago quarter.

Simply annualizing Q4 recurring revenue in the threerecord-setting product segments suggests that fiscal 2008 should also producerecurring revenue records.

Gross profit was 58% and 54% for the full year and quarterrespectively, as compared to 65% and 58% for the comparable prior year periods.Adjusting 2007 gross profit performance for the one-time charge as recorded by Stargameswould have increased gross profit to 61% and 57% for the year and quarterrespectively.

2007 gross profit was also significantly impacted by productrevenue mix. Electronic table system and electronic gaming machine revenue,which grow off lower gross profit percentages than our utility products andproprietary table games, grew to 38% of total revenue for the 2007 year and 46%for Q4, compared to 23% and 30% respectively for the prior periods.

Our value engineering and cost reduction strategy had littleimpact on gross profit in 2007 but these programs should start to positivelyimpact gross profit starting in late fiscal 2008. The increase in recurringrevenue as a percentage of total revenue also positively impacts gross profitpercentages in future periods as leased gross profit percentages are higherthan sales gross profit percentages in all of our product segments.

Operating expenses increased by over $15 million from $64million in the 2006 year to almost $79 million in 2007. The 2006 total has beenadjusted for the gain on sale of the patent and the IPR&D write-off, thenet effect of which is to reduce 2006 operating expenses by almost $15 million.

Q4 operating expenses increased by over $5 million from $17million in the 2006 quarter to over $22 million in the current quarter.SG&A expense for the full year increased by $11 million to over $61 millionand R&D spending increased by over $4 million to over $17 million.

There are a number of factors impacting the year-over-yearincrease in operating expenses, including the significantly weaker U.S. dollar,which increased foreign subsidiary operating expense translated to U.S. dollarsby about $2 million; a full year of Stargames operating expenses in fiscal ’07versus the nine months in fiscal ’06, the impact of which is about $5 million;investing in necessary infrastructure in accounting, finance, productmanagement, sales, and general management to support our growing and increasinglyglobal business; and executive severance and costs associated with the classaction lawsuits totaling about $1 million; and finally, an increase incorporate legal fees of approximately $900,000, related primarily to severallawsuits.

Operating expenses increased from 39% of total revenue in2006 to 44% in 2007. Given the factors involved in the year-over-year increaseand the growing maturity of our infrastructure, we believe that operatingexpenses will begin to stabilize at levels slightly higher than the Q4 2007annualized run rate.

Fixed cost leveraging will begin in 2008 and continuethereafter, ultimately reducing operating expense as a percentage of revenue.

Our income tax rate for the 2007 year was a benefit of 14%compared to the 2006 expense rate of 71.5%. This difference relates torecording amortizable tax basis for the Stargames PC4 technology. Previously in2006, we had determined that a tax deduction related to this technology was notlikely. The availability of a deduction was dependent on interpretation ofnewly enacted Australian tax consolidation rules and initial guidance indicatedthat a tax deduction would not be available for this technology.

During the tax consolidation process in ’07, it wasdetermined that a tax deduction may be available. The tax return which wasfinalized in the fourth quarter reflected our belief that it is more likelythan not that tax amortization is appropriate for the PC4 technology. As such,we recorded the amortizable asset and reduced income tax expense in Q4. Withoutthe impact of this deduction, the tax rates for 2007 and 2006 would have been32.9% and 35.3% respectively. It is anticipated that the 2008 rate will also bebelow the 35% U.S. statutory rate.

The Q4 2007 tax rate was a credit of 227% as a result ofthis deduction, compared to 43% for Q4 of ’06. The Q4 2007 rate would have been41% excluding this deduction.

Given the number and magnitude of the one-time charges andbenefits in our FY07 results, let me spend a minute normalizing our Q4 and fullyear 2007 EPS performance. Reported EPS in our press release today was $0.46for the full year and $0.23 for Q4. The impact of one-time charges at Stargamesfor the WMS minimum royalty guarantee shortfalls, inventory adjustments, a customerreturn related to a pre-acquisition agreement, and executive severance totaled$0.11 for the year and $0.05 for the quarter.

One-time class action legal fees at SMI Corporate were $0.01for the year and the PC4 amortizable tax asset benefit was $0.19 for both theyear and the quarter. Accordingly, normalized EPS would be $0.40 for the yearand $0.10 for the quarter.

Please note that I have not attempted to make any adjustmentfor the $3.1 million of foreign exchange losses we incurred in FY07.

Turning to our balance sheet at year-end, receivablecollections continue to be efficient, with year-end 2007 DSO at about 46 days,slightly lower than the 51 days at the prior year-end. Inventories increasedsignificantly from $24.7 million at the end of 2006 to $34.1 million at the endof 2007. Year-end 2007 inventories were, however, reduced by over $2 millionfrom the $36.3 million at the end of Q3 2007 and inventory reduction is a keycomponent of our balance sheet management strategy as we move forward.

Net debt increased by about $5 million from $227 million atyear-end 2006 to $232 million at the end of 2007, as we utilized available cashin our credit facility to complete the immediately accretive acquisition ofPGIC’s table game division in late September of 2007. Net debt, for example, atthe end of Q3 of 2007 was $210 million, or $17 million lower than at the end of2006.

EBITDA decreased by over 24% from the 2006 record of $64.2million, which excludes the $4.6 million one-time gain on the sale of a patentto $48.8 million. Q4 EBITDA decreased by a percentage to $12 million comparedto $15.6 million for the 2006 quarter.

Full year and Q4 2007 EBITDA would have totaled $54 millionand $14 million, excluding the impact of one-time charges of $6 million and $2million respectively.

Operating cash flow was $32.4 million for the 2007 year, aslight reduction from the $34 million for 2006. Cash and cash equivalentstotaled $4.4 million at the end of 2007 compared to $8.9 million at the end of2006.

Moving away from the financial statements and metrics, Iwould like to touch on a few of our more noteworthy product accomplishments.

The rollout of our new single deck Ideal Shuffler commencedin Q4 with an installed base at year end of 49 units. Our proprietary tablegame lease space increased by almost 1,000 units, including the approximately600 tables included in the PGIC table game division acquisition. Our fastestgrowing premium game, Ultimate Texas Hold’em, finished 2007 with over 250 tablesunder lease.

Several of our table games were approved for trial in theU.K. in September of 2007. There are 23 full games and 47 side bets now ontrial and we expect at least some of these tables will be leased at theconclusion of the trial in February.

Our e-table lease space increased by almost 700 seats, orabout three times the increase in 2006 and finally, the sale of EGM unitsfeaturing content developed by our Stargames subsidiary reached a record 2,254for the 2007 year compared to 940 for the nine months of 2006 respectively.

With that, I would like to turn the call back over to Mark.

Mark L. Yoseloff

During our last several calls, we’ve reviewed our progressagainst our five key initiatives that we believe will drive our long-termstrategy. We continue to make progress on all of these initiatives and I wouldlike to particularly highlight two of these at this time.

First, our renewed emphasis on leasing versus selling -- aspreviously discussed, this strategic initiative is currently directed primarilytoward North America, although we have begun some modest leasing programs inother parts of the world and hope to extend these in the future.

Total North American recurring revenue for the quarterexcluding Internet related revenue was a record $14.9 million, or 65% of totalNorth American revenue, again excluding Internet related revenue.

The trend here is extremely positive, given that comparablerevenue was over $1 million less than this in the prior quarter and only 54% oftotal revenue in the year-ago quarter.

During our third quarter conference call, I discussed ourprogress in implementing the strategic initiative which is to increase revenuefrom existing assets in the field by upgrading or adding new value elements tothese existing products. We continue to make excellent progress throughout ourorganization in providing these new revenue drivers.

As discussed in the past, adding new wagers to existingtable games is one of the ways to implement this strategy. At the end of thefourth quarter, we had installed or pending installation about 135 such tables,none of which existed prior to instituting this initiative this year.

Although as we decided in January 2007 we are not at presentproviding detailed quantitative financial guidance, I would like to provide anupdate to the discussion of segment growth rates as first discussed during ourfiscal 2007 second quarter earnings conference call last year.

At that time, we forecast five-year compound annual growthrates for each of our major business segments. Specifically, these five-yearCAGRs were 10% to 15% for utility products, 20% to 24% for proprietary games,at least 30% for electronic table games, with relatively flat revenue growthfor electronic gaming and machines.

Based on our fiscal 2008 budget, we now anticipate meetingor exceeding these growth rates in fiscal 2008 with the exception of ourutility product segment. In this segment, we anticipate that increases inrecurring revenue will be well within our five-year target range.

However, on an overall basis, utility products may fallshort of this five-year rate in this fiscal year due to shuffler sales growthfalling below this target as a result of several factors, including the renewedemphasis on leasing and the timing of new casino openings, particularly inAsia. Any shortfall in this segment appears to be more than mitigated bypotential upsides in the other segments.

Finally, we remain comfortable with these segment growthrates over the five-year period.

I will now turn the call back to Joe, our operator, forQ&A.

Question-and-AnswerSession

Operator

(Operator Instructions) Our first question is from Joe Greffwith Bear Stearns. Please go ahead with your questions.

Joe Greff - BearStearns

Mark, maybe you can give us an update on the search for theCO and CFO spots?

Mark L. Yoseloff

I’m sorry?

Joe Greff - BearStearns

Maybe you can give us an update on the executive searchfront, the two positions?

Mark L. Yoseloff

Sure. As you know, we announced that the board is lookingfor possible successors for me as the CEO, with my cooperation, and this issomething that had been anticipated for some time and has been in progress forsome time. There is no specific deadline on this. It’s rather open-ended in thesense that one of the major responsibilities obviously of the board is toconsider succession planning for the CEO spot. And so this is an ongoingprocess and certainly there is no progress to report today of any magnitude orsignificance.

As far as the CFO, Paul as you know is Acting CFO. We areprobably going to institute a search for this position and look for a new CFO.We have not done that yet but we probably will be doing that soon. It’s animportant role in this company and it’s certainly a full-time job. We probablyneed to replace the position. We are going to need to find someone who has theright qualifications, including the right amount probably of internationalexperience as our company becomes a more and more global company.

Joe Greff - BearStearns

Good enough. And Paul, I have a couple of numbers relatedquestions; I know you include in the back of the press release cash flows frominvestment activities. Can you break that out a little bit? What’s CapEx,what’s related to progressive --

Paul C. Meyer

Well, I can but actually, I’d rather not do that yet sincewe are still working on those details. I mean, we feel pretty comfortable, Joe,with those totals but the details are not yet ticked and tacked.

Joe Greff - BearStearns

Where do you see CapEx for next year?

Paul C. Meyer

As you know, our CapEx is essentially related to productsthat we acquire to lease out, so I would basically look at our CapEx as beingconsistent with our incremental leasing revenues, you know, on a cost basis. Idon’t have the exact number in front of me.

Mark L. Yoseloff

I think you could do some modeling of that, Joe. You knowwhat our margins look like and the categories. You know we’re looking for newleases and I think based on that -- other than that kind of CapEx, as far asany other CapEx, it’s generally not a terribly significant number.

Joe Greff - BearStearns

And then the sequential increase in the table games leasespace, can you break that out, the incremental -- I guess quarterly changebetween the number of side bet units and then what we consider the moretraditional game units?

Mark L. Yoseloff

We could probably try and get you that detail. I am not surewe can do it on the call.

Joe Greff - BearStearns

Okay. Will that be in the K?

Mark L. Yoseloff

Well, there will be some more detail in the K but what’sinteresting now is we are looking at this issue of when we lease or in the pasthave sold a game and now we go back and we add a side bet to one of our ownpremium games, we’re looking at how to log all that so that it’s easy to followfor our investors. I think it’s interesting now because, for example, we haveeither installed or pending 100 or more Fortune Pai Gow Poker progressive sidebets, and so it’s an interesting category -- it’s a side bet on a side bet on agame that we basically control.

This is a very high class kind of problem to have. How do wequantify and catalog all this revenue we are going to have?

Paul C. Meyer

I can tell you though, I mean, looking at some of the detailwe have available, Joe, that the sequential increase in proprietary table gamelease revenue Q3 to Q4, only about $30,000 of that increase was in side bets.

Joe Greff - BearStearns

Okay, that’s helpful. Great, thanks, guys.

Operator

The next question is from Steven Wieczynski with StifelNicolaus. Please state your question.

Steven Wieczynski -Stifel Nicolaus

First, a housekeeping question; can you break out more interms of the other income line? There’s $3.4 million in there -- can you justbreak out what’s expense, what’s income?

Paul C. Meyer

Actually, surprisingly enough I had covered that in myscript. By the time we finished reading it, Steve, we’re so bloody wellconfusing -- I tell you what, why don’t we do this -- I can do that. Why don’twe take that offline?

Steven Wieczynski -Stifel Nicolaus

Okay.

Paul C. Meyer

I have that detail -- a number of items in there, obviouslyinterest expense, as you know, is in there. That was impacted by new loanfacility fees that we incurred in Q1 of ’07. Last year we took about a $1.7million impairment hit on our Sona mobile investment. That’s in there. Foreignexchange is in there, but I can go through the detail with you.

Steven Wieczynski -Stifel Nicolaus

And then second, can you just give an update in terms of thee-table market and what new markets you are out there targeting at this point?

Mark L. Yoseloff

I’m happy to do that. The progress we’ve made in e-tables inthe last year I think has surprised us. The market appears to be growing alittle more quickly than we anticipated, particularly in North America, and sowe have the usual suspects -- Delaware, Pennsylvania, [casino] marketsgenerally. I read a comment recently in a report that we might now be goinginto Rhode Island. The fact is, we are already in Rhode Island. We have movedquickly into a lot of jurisdictions.

The most interesting observation I will make, and it’s veryearly in the game, is that we seem to be making good progress with both our rapidstyle electronic wagering with a live outcome, and our table master or Vegasstar style fully electronic games in traditional casinos that also have thecapability to offer live games.

Now, we don’t see this progress frankly in theall-electronic games in the high end casinos but where we do see it is in themore modestly priced casinos where a $2 or $3 minimum three-card poker orblackjack may be competing in the casino with a $5 minimum table, live table.

And the interesting fact that we are seeing is that theelectronic tables are out-earning the live tables. So the casino gets thedouble benefit of a fixed cost, 24-hour a day operating table that actuallygenerates more income than the higher cost live table. We are certainly hopefulthat trend will continue.

And then in the most macro sense, our expectation still isover the next five years, the largest growth market for e-tables will be NorthAmerica and that seems to be borne out by the evidence we are seeing lately aswell.

Steven Wieczynski -Stifel Nicolaus

Okay, and just one more -- I’m not sure if you’ll be able toreally give a good answer on this but in terms of where the stock price is now,it’s $10. If you guys really think -- you basically kind of committed that thiscould be the turnaround point. At what point do you as upper management and theboard kind of step in and either make a good sizable share repurchase or asindividuals kind of step in?

Mark L. Yoseloff

I think we’ve been precluded from making purchases by anumber of factors and I would say that even today -- well, certainly today weare still in a quiet period.

Steven Wieczynski -Stifel Nicolaus

Okay. Thanks, guys.

Mark L. Yoseloff

I just want to finish the comment -- it’s not for lack ofdesire on the part of senior management that we have not been personal buyers.

Steven Wieczynski -Stifel Nicolaus

Okay. Thanks, guys.

Operator

The next question is from Joanie Jensen with McMahonSecurities. Please state your question.

Joanie Jensen -McMahon Securities

Thanks for taking my question. In regard to your convertiblebond put coming up in a little over a year, I was wondering if you couldaddress how you are thinking about that right now? And also, what your currentliquidity situation is as far as revolver availability and other options youmay be considering?

Paul C. Meyer

I’m happy to address that. We’ve started -- it’s not tooearly to start thinking about what happens in April of ’09 if as we believe thebond holders will exercise their ability to put the bonds back to us. Clearlythere are a couple of different options were we to refinance those bonds A,with a new convert; B, with a secondary. We are looking at those options rightnow.

The good news is the list of significant holders of ourconvert is not a very, very long list so I think it won’t be too far from nowthat we accelerate our strategic planning and in fact start to have somediscussions with major holders of those bonds.

Joanie Jensen -McMahon Securities

Okay, so essentially you are looking to refinance it in someway, shape, or form?

Paul C. Meyer

Yes, which of course, if they didn’t exercise their putright we wouldn’t exercise our call right, so we wouldn’t have to do that butof course, we would anticipate, unless something dramatic happens between nowand April of ’09, they will in fact exercise, or a majority of them willexercise their put rights.

Joanie Jensen -McMahon Securities

And do you have a sense how soon this will be completed?

Paul C. Meyer

Well, that’s one of the issues we’ll talk -- we have to talkto our advisors about, when the right timing is. As you know, from a timingperspective, the ultimate timing will depend upon A, what avenue we choose andB, what the market conditions are at that time. I mean, we certainly aren’tgoing to do anything too early, nor would we want to do anything too late, so--

Joanie Jensen -McMahon Securities

Okay. Thank you.

Paul C. Meyer

That will be a function of market at that point.

Operator

The next question is from Ryan Worst with Brean Murray.Please go ahead with your question.

Ryan Worst - BreanMurray Carret

Just a couple of questions; one, on the WMS shortfall, thiswas the second quarter where you guys had to make that up. Is that the finalpayment that you guys are required to make?

Mark L. Yoseloff

Yes, it is the final payment. The way the agreement waswritten, we had various stages of the agreement and at certain milestonepoints, we had to true-up and make any royalty shortfall payment. The one thatwe made in Q4 includes our anticipation of any royalty shortfall through theend of January of 2008 when the agreement will terminate.

Ryan Worst - BreanMurray Carret

Okay, and then Mark or Paul, can you talk about the SG&Aincrease in the quarter? I mean sequentially, you’re up almost $2 million.

Paul C. Meyer

Well, obviously what we’ve been doing -- actually, maybeit’s not obvious, Ryan. We’ve been from an SG&A perspective, adding staff.We’ve been staffing up in finance and accounting and even though we expectultimately that will reduce some of the consulting fees that we’ve incurred,there is some overlap and that’s what’s happening there, number one.

Number two, of course, we’re in the year-end audit periodwhich started obviously before the fiscal year ends, but I say when we gettogether, I can probably give you a little more color or specificity.

What I wanted to try to communicate in my part of the scriptis to give everybody some reasonable expectation as to where OpEx would start,including SG&A, would start to stabilize.

Ryan Worst - BreanMurray Carret

Right. What about the SG&A portion? Should it be comingdown from that $16 million, or you think that’s a good number going forward?

Paul C. Meyer

No, I don’t think it’s going to be coming down. I mean, Ithink there are a couple of factors that may help mitigate any increase. Forexample, we expect as we go forward and we become more effective in ouraccounting and finance sections, which we are now, there could be some reductiongoing forward in audit fees. There certainly will be some reduction inconsulting fees.

On the other hand, SG&A includes certain variable costslike sales commissions, so as revenues increase, the absolute dollars of salescommissions increase as well.

Ryan Worst - BreanMurray Carret

Okay. All right, that’s it. Thanks.

Operator

The next question is from Bill Lerner with Deutsche Bank.Please go ahead with your question.

Bill Lerner -Deutsche Bank Securities

Thanks, guys. Actually, two questions; one, Paul, I justwanted to just flush it out for another second on this minimum guarantee thingwith WMS, why does it make sense to add back the impact if that was acontractual story all along? I mean, I understand you don’t have revenue tooffset, to benefit from there and that changes going forward. But I just wantedto get your thoughts a little more on that.

And then the second one was as you go back and sort of Iguess autopsy 2006, what would you change or what changes going forward? Imean, was it a function of more than anything, sort of distribution orover-paying and so therefore capital structure as it relates to Stargames, oryou know -- I just wanted to get a little more color on that.

Paul C. Meyer

Let me try to -- I assume the second component, you aretalking about 2007, not 2006.

Bill Lerner -Deutsche Bank Securities

Yes, your fiscal, yes.

Paul C. Meyer

Let me talk about WMS -- the reason we add it back, or I didcertainly in terms of normalizing EPS, is since the deal terminates January 31and I can tell you although we are in discussion with other possible contentproviders for the Stargames slot line, none of them will have a minimum royaltyguarantee, so as far as we’re concerned, minimum royalty guarantee shortfallsfor the EGM business or for the business in general are non-recurring andone-time. We probably would not have taken that position if the WMS agreementwasn’t terminating by mutual agreement as of January 31st of 2008.

Secondly, in terms of what -- and I’d like Mark to commentas well, but in terms of what in retrospect, some of the things we could havedone differently, we certainly could have transferred our Vice President ofFinance from Las Vegas to Sydney much earlier. We see the impact she’s had inmoving over there in April and that’s something in retrospect we probably couldhave done a little bit earlier and probably picked up a few months on theprogress we’ve made at Stargames.

Bill Lerner -Deutsche Bank Securities

But from a product perspective, I would suspect you’d sayobviously the Stargames product may be the next CGMs or ignore EGMs for asecond, you would have done that again and perhaps paid a similar amount?

Mark L. Yoseloff

I’m going to comment on that because there’s been certainlya substantial amount of criticism that has focused on the Stargames acquisitionand I several times in my remarks suggested that certain things have takenlonger than we had originally anticipated, which they have. Certainly scrubbingthe balance sheet, getting the staffing down, getting all the right controls --you know, it just took a little longer.

But the good news is it’s done. On the positive side, whichI think is very important to focus on, what appears to be the fastest growingcategory right now in our industry, which is e-tables -- now, it’s the fastestgrowing because the original base was so small but it’s growing at an incredible rate and we are an industry leaderarguably in all six continents where there is gaming, but certainly in three orfour continents, we are the undisputed leader in the category and that’sprimarily due to the acquisition of Stargames.

So only history looking back in a few years will be able totell us whether we were right or wrong as far as what we paid, but I am not atall uncomfortable with the transaction and right now I am extremely pleasedwith the product and the performance of the product, which is just outstanding.

And by the way, even the EGM business, when the dust allsettled at the end of 2007, when we discovered that we had placed almost 2,300units of Stargames generated content in the year as opposed to 900 units in thefirst nine months we owned the company, I think all of us were amazed at theprogress we made in that category.

Bill Lerner - DeutscheBank Securities

Okay. Thanks, guys.

Operator

(Operator Instructions) The next question is from RalphSchackart with William Blair. Please go ahead with your question.

Ralph Schackart -William Blair

Two questions; the first one is just more of a strategic,long-term, Mark. I’m just wondering if maybe you could use some baseballanalogy for us, just sort of frame for us where you are in this transition,sort of heavy lifting, maybe in baseball innings for us. Are we middle to latestages? I’m just trying to frame how much more heavy lifting we have to dohere.

Mark L. Yoseloff

I think as I said in the press release, and I’m just goingto look at that for a second, I think that we are through a lot of the mostdifficult times here. We had to do a couple of things all at once and thehardest times were when we were at the same time trying to implement certainkey strategic initiatives and complete the integration of Stargames, andcertainly in 2007 this was an ongoing task for all of the management hereduring the year.

As I look now at the acceptance of our strategicinitiatives, particularly the leasing initiative or the adding additionalwagering to existing games, all of these things that will generate incrementalrevenue for us in a very, very effective way, and I look at the acceptance ofthat by our customers, I am gratified by the rate at which this is going on.

I think now we’ve gone from implementing a strategy withsome amount of uncertainty as to the likely acceptance of that strategy by ourcustomers to simply moving our sales force into high gear and getting even morerecurring revenue, placing more additional wagers on existing games, placingnewer model shufflers and so on.

Stargames, same thing -- a year ago, we had a number of issuesthat we needed to deal with and we spent a lot of time during this year and asyou know, on each call we gave you progress but there was always this item orthat item. And finally, with some reasonably good assurance, I can say to youthat’s done. We feel very good about Stargames.

I was asked a question earlier today and that is whatconcerns do I still have about Stargames in that regard. And I’ll tell you thatthe answer is very simple -- I have no concerns regarding Stargames that areany different than the normal business concerns we would have about any segmentof our business or any geographic region, and that’s really the first time Ican say that with great assurance.

So yes, a lot of the heavy lifting thank goodness is behindus and hopefully some very good times are ahead of us.

Ralph Schackart -William Blair

Great, that was helpful, Mark, and one more question, if Icould; you talked about operating margin leverage or expansion modestly on ago-forward basis, and you talked about SG&A being sort of flat at best, andthen there’s obviously been a trend in gross margin compression. I’m justtrying to understand where the operating leverage is going to come from on theOpEx line.

Mark L. Yoseloff

I’ll comment and then Paul may want to comment as well. Ithink there’s leverage in two places. I think we should start with the grossmargin line because Paul commented on it but it may have been lost becausethere was so much detail, but our strategic initiative, which is the valueengineering of our products, although it began in 2007 until we cost reduce andimplement these cost reductions in the production of product, there is quite asubstantial lead time.

We’ve now seen some of these cost reductions. We’ve seen thephysical embodiment of these in prototype form from our engineers and I cantell you that we are reassured that we are going to be able to improve grossmargins by cost reduction in the products with absolutely no change in theperformance or quality of the products, number one.

And number two, as with all growth companies, not everythinggrows in tandem. We’ve gone through a period now where we simply had to buildinfrastructure.

We’ve implemented some new accounting software andforecasting software. We’ve added people. We’ve done a lot of things that havetended to reduce our operating margin because we’ve increased OpEx. But a lotof that’s done as well, a lot of that heavy lifting is done and hence, asrevenue grows now, it’s our expectation that we’ll be able to enjoy thebenefits of this infrastructure for quite a bit of additional revenue growthbefore we are again challenged by hitting the infrastructure wall and having togo even bigger.

So from my perspective, those are the two major elements andPaul may want to comment as well.

Paul C. Meyer

I can amplify what Mark said and really not say muchdifferent. Where we see the leverage coming from, as I tried to suggest in mycomments during the conference call, was we clearly believe that the rate ofincrease in OpEx for years beyond 2008 will not parallel the rate of increasein revenues. As Mark went through his CAGR update, there’s no question thatgiven the amount of infrastructure building we’ve done, given the fact that wehave 12 months of Stargames in ’07 versus nine months in ’06, given the factthat nobody believes that the U.S. dollar will continue to weaken at the samerate it has over the past 12 or 15 months, we fully believe there is no reasonwhy OpEx as a percentage of revenue shouldn’t start to come down towards theend of ’08.

Ralph Schackart -William Blair

Great. Thank you for both explanations.

Operator

The next question is a follow-up from Bill Lerner withDeutsche Bank. Please go ahead with your question.

Bill Lerner -Deutsche Bank Securities

One more, just to follow-up on -- I know, Mark, you talkedabout not wanting to get -- engage in EPS guidance yet but could we just talk alittle more generally about how to think of next year and directionally whereearnings are perhaps going?

And as I think about it, of course you were doing the rightthing from everybody’s perspective moving back towards lease. There’s a coupleyear impact to make that up. You’ve already begun on that path obviously butless sales, more lease. Paul, you talked about higher SG&A it sounds likeas a percentage of revenues and of course on an absolute basis. Greaterinterest expense because of the [inaudible] at convert or more shares if youengage in a secondary offering route to handle that.

So as we think about earnings and maybe I need to reconsiderwhat the right metric is, whether it’s cash flow or earnings, how do we thinkabout 2008? Is your view of not to reestablish guidance in terms of earnings afunction of visibility or what?

Mark L. Yoseloff

I think we have excellent visibility right now. We’ve spentmore time and effort on our fiscal 2008 budget than I think we have in the paston any budget. But of course the company, as it gets bigger and morecomplicated, requires that.

The reason we’ve elected, and I think a lot of companies areelecting not to provide this type of detailed financial guidance, is that thereis substantial modeling of our business being done and I think for us toprovide this at this stage frankly, I’ll be blunt, is a trap and it’s a trapthat we don’t really want to engage in.

My objective, and I’ve said this all along, I am runningthis business for the sake of our long-term shareholders and doing everything Ibelieve is right. And I’ve been doing this for almost 10 years now and I don’tthink I’ve disappointed the long-term shareholders all that much over the timeperiod.

And we do it by building strategic initiatives and thenfollowing through in a patient and dedicated way. I think we’ve told theinvestment community precisely what it is we are going to do. I laid out thefive strategic initiatives. I think we’ve been consistent on every call. Iupdate everyone as to how we’re doing. I’ve given you growth CAGRs in each ofour categories so that we can all have some point of reference as to how wethink our business is going to grow.

I think Paul has outlined very well what our expectationsare in regard to OpEx and other expenses. We’ve talked a lot about gross marginand what we think will happen there.

You know, I used to be a college professor, so I think afterwe give you the revenue growth CAGRs, our thoughts on gross margin and our OpExthoughts, then I leave the rest as an exercise to the reader, as they used tosay in the textbooks.

Bill Lerner -Deutsche Bank Securities

Okay.

Operator

At this time, I am showing no further questions in queue. Iwould like to turn the call back over to management.

David Sandler

I want to thank everyone for joining us and expect to -- Ithink there may be one more question -- and I want to thank you all and we’llspeak to you all on the next call. Thank you.

Operator

Ladies and gentlemen, this concludes today’s teleconference.Thank you for your participation.

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