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Executives

Bill Pfund - VP, IR

Brian Gamache - President and CEO

Orrin Edidin - EVP and COO

Scott Schweinfurth - EVP, CFO and Treasurer

Analysts

Joseph Greff - Bear Stearns

Steve Kent - Goldman Sachs

Bill Lerner - Deutsche Bank

Kent Green - Boston American Asset Management

David Katz - Oppenheimer

Celeste Brown - Morgan Stanley

Todd Eilers - Roth Capital

Steve Altebrando - Sidoti

Steven Wieczynski - Stifel Nicolaus

Joe Herrick - Gutterman Research

WMS Industries Inc. (WMS-OLD) F2Q08 (Qtr End 12/31/2007) Earnings Call February 6, 2008 4:30 PM ET

Operator

Welcome to the WMS Industries' fiscal 2008 second quarter results conference call. (Operator Instructions)

I would now like to turn the conference over to Bill Pfund, Vice President of Investor Relations. Please go ahead, sir.

Bill Pfund

Thank you, operator, and welcome, everyone, to WMS's fiscal 2008 second quarter conference call. With me today are Brian Gamache, our President and Chief Executive Officer; Orrin Edidin, Executive Vice President and Chief Operating Officer; and Scott Schweinfurth, Executive Vice President, Chief Financial Officer and Treasurer.

Before we start, I would like to review our Safe Harbor language. Our call today contains forward-looking statements concerning the outlook for WMS and future business conditions. These statements are based on currently available information and involve certain risks and uncertainties. The Company's actual results could differ materially from those anticipated in the forward-looking statements depending on the factors described under Item 1, Business Risk Factors in the Company's annual report on Form 10-K for the year ended June 30, 2007, and in our more recent reports filed with the SEC.

The forward-looking statements made on this call and webcast, the archived version of the webcast and any transcripts of this call are only made as of this date, February 6, 2008.

Now, let me turn the call over to Brian.

Brian Gamache

Thank you, Bill, and good afternoon, everyone. Today, WMS reported a 31% increase in net income of $16 million or $0.27 per diluted share for the fiscal 2008 second quarter on record revenue of $159 million.

Reflecting the continued higher performance of our innovative products, revenues handsomely exceeded our revenues guidance of $143 million to $148 million. WMS's broad-based strong financial performance reflects the great success we're achieving by offering highly innovative products, while simultaneously generating substantial improvements in our operational efficiencies.

In the December 2007 quarter, our internal efficiency initiatives and improved operating consistency led to a 260 basis point rise on our operating margin to 15%. And these initiatives were also instrumental in driving a higher level of cash flow from operations.

Our focus on operational excellence has been manifested in the consistency in operating results we believe is sustainable, and reflects our success for the five key strategic priorities that we've been discussing for the last several quarters, including growing our domestic market share, expanding this growth in profits generated by our international operations, continuing to grow our gaming operations footprint and (inaudible) contribution, achieving margin improvements and elevating our cash flow and capital returns.

By leveraging prior investments in intellectual property to advance gaming technology to drive innovation in game design and focusing our capital and human resources in high return opportunities, we are now delivering record quarterly results by also positioning the company for sustained long-term growth.

I am extremely proud of the success of our entire organization has accomplished this past quarter and the continued operation momentum that we've achieved over the past few years.

Our topline growth, the substantial increase in earnings and our improving cash flow are visible indications of the significantly strengthened competitive position we've built, but while meaningful in and of themselves, our success today is only the beginning of what we believe we can achieve going forward.

Our emphasis on innovation on developing unique and appealing products and on improving our operating processes has established a solid foundation. We expect to capitalize on the significant opportunities in the future from new and expanding jurisdictions worldwide and from and from sever-enabled next-generation gaming products and applications.

Those of you who attended the G2E Trade Show in November 2007, experienced the sampling of the award-winning products and applications we expect to offer in both the near and longer term that leverage our advanced technology licenses and expanded IP portfolio.

This focus on creating new gaming capabilities has allowed us to bring to market differentiating content and unique products. Strategies have been and are simultaneously driving near-term growth and building sustainable long-term profit growth.

Now, let me turn the call over to Orrin who will provide additional perspective on operating performance during the second quarter. Orrin?

Orrin Edidin

Thanks, Brian, and good afternoon, everyone. As Brian mentioned, we are laser-focused on delivering continued progress against our five strategic priorities.

First, we continue to successfully amend the expansion of our high-margin gaming operations business to achieve an optimal balance of growth in our installed footprint and higher revenue per day.

For the December 2007 quarter, our gaming operations business achieved another outstanding quarter. Our average installed base of participation gaming machines increased 23% over the last year. And at quarter end, our installed participation footprint stood at 9,186 units.

Importantly, in addition to the greater than anticipated quarterly sequential growth in standalone units, we were able to increase our percentage of WAP units in the total installed base, and these units comprise 20% of the period-end footprint, up from 19% the September 30, 2007.

This installed base growth combined with a 9% increase in average daily revenue in the December 2007 quarter produced an impressive 34% year-over-year increase in revenue from our gaming operations business.

This growth principally reflects the continued strong performance of the three innovative participant platforms we launched in fiscal 2007: Community Gaming, Sensory Immersion Gaming and our Transmissive Reels Gaming platforms. We are continuing to build on our effective strategy of introducing category-creating gaming platforms as the catalyst to grow this business.

Our installed base of standalone participation gaming machines at quarter end increased 26% over the prior year and 8% or 360 units on a quarterly sequential basis from September. This exceptional growth reflects additional placements of our Big Event community gaming machines, including both MONOPOLY and PRESS YOUR LUCK titles. As of December 31, 2007 there were more than 2,100 Big Event units installed.

Our Sensory Immersion platform initially launched with the very successful Top Gun game in March 2007 is achieving even higher levels of performance with the launch of the Wizard of Oz game in the December 2007 quarter.

The initial Oz units have exceeded the performance of any prior WMS gaming product, including both TOP GUN and Transmissive Reel products. Oz was also recently rated the top Hot Pick game for 2008 by Casino Player Magazine where WMS had four games overall rated into the top 15, double the number of any other equipment supplier.

Our Transmissive Reels platform installed footprint also increased on a quarterly sequential basis, as we introduced JOHN WAYNE games to compliment the continued rollout of the initial MONOPOLY Super Money Grab games.

Maintaining the discipline of a controlled rollout for these new products is delivering the desired result of a higher level of incremental footprint for these WAP units. The area installed footprint for both our Sensory Immersion and Transmissive Reels platforms exceeded 1,600 units at December 31 2007.

We expect to generate another quarter of solid double-digit year-over-year revenue growth in our gaming operation segment in the March 2008 quarter. However, with no new games being introduced at these platforms until the June 2008 quarter and no new casino openings offering subsequent participation footprint opportunities, we expect the installed base of gaming machines to remain relatively stable during the March quarter.

We expect the installed base will grow again in the June quarter and through fiscal 2009 with the expected launch of our Bigger Bang Big Event game and the introduction of STAR TREK, the first title on our newest innovative and category creating adaptive gaming platform, as well as the Bruce Lee Transmissive Reels product and the HAPPY DAYS, multi-level free spin games, all of which we previewed at G2E.

Our second priority is to continue growing our North American market share. The December quarter was a tough comparison as last year included the initial product sales from the opening of both the New Pennsylvania and Broward County, Florida jurisdictions, which represented nearly 30% or more than 1,400 units. Nevertheless, with the high demand for innovative products, revenues from North American shipments declined to 7%.

Our ability to create innovative and differentiated games forms the backbone of our high player appeal products, which generate solid financial returns for our customers coupled this with our increased breadth of product in especially the mechanical reel category, which accounted for 30% of our new units sold in December 2007 quarter, and WMS continues to capture a greater portion of operators' capital being applicated to gaming machine purchases.

Growing WMS's global market presence, our third priority, achieve exceptional results, were 47% revenue growth in the December quarter. International revenues were driven by strong demand across the range of international markets from Asia to Latin America to Europe.

Shipments in international markets represent 13% of our total new unit shipments in the December 2000 quarter compared to 25% a year ago. The addition of Orion and Systems In Progress or SiP also are contributing to WMS's expanding worldwide presence as we can offer international customers of varying sizes and markets with a complete solution for their casino floors.

And at the recent ICE Show in London, Orion showcased their new Twinstar 2 cabinet and advanced operating system to very positive customer reviews. In addition, as many of you are aware, we had a licensing agreement with Star Games whereby we provided our game content to Star Games for use at their gaming platform in Australia and New Zealand in return for royalty payments.

We've chosen not to renew that arrangement as we seek to enter these important markets directly with our full array of high-performing innovative products. Longer term, we believe these markets offer significant profitable growth opportunity to take advantage of our common CPU-NXT operating platform that has been helping to power our growth in other international markets.

And our talented Sydney-based development group is rapidly transitioning to a full-time CPU-NXT studio to better leverage their strength on a global basis.

Our fourth priority is to enhance our operating margin. In this quarter, our operating margin increased to 15.1% from 12.5% a year ago. This growth was largely driven by the 410 basis point improvement in total gross margin. Though still early in implementing our strategic sourcing in Lean Sigma initiatives, we're very pleased with the operating results being achieved and the potential for further gains.

This means we expect to continue to deliver enhanced operating margin even as we invest more heavily in R&D activities that support innovation and the creation of intellectual property and advanced technologies, which contributes to building sustainable profitability and stockholder value in the medium and longer term.

Our fifth priority is to drive higher cash flow during the December 2007 quarter, net cash provided by operations improved by more than $12 million to $31 million while our year-to-date six-month operating cash flow increased 57% to $70 million compared to $45 million for the comparable six-month period last year.

Now, before I turn the call over to Scott who will discuss his priority and share his perspective on our financial performance, I'd like to update you on our server-enabled gaming initiatives. To briefly review, we are facilitating a unique path to the server-enabled marketplace that takes elements of our technology roadmap and converts them into commercialized revenue-producing products in advance of the launch of a full functionality of server-based gaming.

We previewed another step-forward in this strategy with our fourth new participation platform adapted gaming, which features Star Trek series of games. These unique new games have the ability to be personalized by players while being able to unlock additional bonus rounds over the time, enabling an episodic reward experience for the player. The player will also be able to restart the game where they last left off whenever the player logs back into a Star Trek game, which is expected to contribute to the players' gaming experience and drive enhanced service performance and longevity of the game.

Additionally, we showcased our Casino Evolved vision in the [walt] area of our booth, including new differentiated games, unique products, innovative applications and new casino services that are enabled in a server-based network world.

These products and other applications demonstrate our capabilities to utilize the power of network gaming to create products that provide unique and innovative gaming experiences for players while providing functionality that offers high financial value to our customers.

The favorable response to these new applications and potential new revenue sources, coupled with continued expansion of our participation product platforms, gives us tremendous confidence in our ability to generate long-term growth.

We remain committed to the open architecture of the GSA communication protocols. This commitment to the interoperability with other manufacturers' products and systems in the server-enabled environment was a clear evidence at both G2E and the more recent ICE trade shows held in London.

Also, along with the focus on the interoperability among gaming products, we demonstrated our new completely server-ready Bluebird2 gaming machine and the latest version of our WAGE-NET server-based system with new features and functionality.

We expect to begin a field trial of our first point release of the basic server-based functionality in a popular GOI-approved casino in the next couple of weeks and then shortly follow that with the Nevada field trial. We continue to expect approval of the first commercial version of the WAGE-NET system in mid-calendar 2009 as previously discussed.

Now, let me turn the call over to Scott to review our financial performance. Scott?

Scott Schweinfurth

Thanks, Orrin, and good afternoon, everyone. Touching on some of the financial highlights for the quarter, our total revenues increased 18% or $25 million year-over-year to $159 million for the December 2007 quarter.

Total revenues exceeded the high end of our revenue guidance primarily due to higher than expected international product sales, higher conversion revenues and better than anticipated North American sales resulting from the positive response to our products G2E and our focused efforts to capture the customers' remaining capital for calendar 2007.

Total product sales revenues was $11 million or 12% year-over-year with the primary contributors being better than anticipated growth in international revenues, which were up 47% and the continued success of our mechanical wheel products. As Brian mentioned, we are particularly proud of this growth in the face of the tough North American comparison to last year, which included a strong contribution from the initial six casino openings in Pennsylvania and Florida.

Our average selling price was up 5% over the prior year to $12,683, primarily reflecting the benefit of higher list prices. Other product sales were also a significant contributor, increasing year-over-year by $5 million, reflecting strong sales of game converging kits and used games.

Conversion kit sales rose to 2,400 units compared to 750 in the prior-year quarter due to the positive response to our new video and mechanical reel games. Gaming operations revenues in the quarter increased 34% or $14 million year-over-year on an average installed base of 8,767 units and the yearly revenue per unit of $60.46.

At December 31, 2007, the total installed base was 9,186 units, an increase of 24% year-over-year and a strong 6% or 492 unit quarterly sequential gain. Total gross profit, excluding depreciation expense, increased 27% or $20 million year-over-year to $94 million in the December 2007 quarter, and total gross profit margin increased 410 basis points year-over-year to 59%.

The gross profit on product sales revenue increased $8 million, and the gross profit margin on product sales increased to 48%, up 310 basis points over the last year. The gross margin from gaming operations was 79% in the December 2000 quarter, essentially flat on a quarterly sequential basis with the September 2007 quarter and modestly ahead of the year-ago period, primarily reflecting the operating leverage from the year-over-year increase in the installed base of high-performing games and lower relative WAP jackpot expense.

Research and development expenses increased 24% or $3 million year-over-year to $17 million. As a percentage of revenue, R&D expenses were 11%. The higher year-over-year level of spending reflects planned higher expenses for product development initiatives, including our server-based activities and the inclusion of R&D expenses for SiP since its acquisition in July 2007. Quarterly depreciation expense of $18 million was $2 million or 11% higher than a year-ago period largely due to the 24% increase in our installed base of participation games.

Selling and administrative expenses were $34 million in December quarter or 21% of total revenues. This compares with 21% of total revenues in the September 2000 quarter and 20% of total revenues in the year-ago period. The year-over-year increase reflects higher payroll related costs associated with improved operating performance and headcount increases during the past 12 months to support our international expansion and overall business growth and increased field service and customer service costs related to the expansion of our participation installed base and focus on improved customer touch points.

We also incurred higher legal costs and a non-cash charge for higher bad debt expense in the December 2007 quarter as well as the impact from the consolidation of SiP, acquired in July 2007. In addition, due to the continued strength of our financial performance, we recorded a non-cash cumulative charge related to certain performance-based equity grants.

We expect selling and administrative costs to decline sequentially in the March 2008 quarter compared with the December 2007 period and to be lower during the remainder of fiscal 2008 as a percentage of total revenues. As a result, we anticipate such costs to be within a range of 19% to 20% of total revenues for fiscal 2008, an improvement from the 20.3% level in fiscal 2007.

The effective tax rate for the December quarter was 34.7% compared with 24.7% in the prior-year period. The December2006 quarter included the cumulative impact from the retroactive enactment of the research and development tax credit.

Since federal legislators have not extended the R&D tax credit beyond December 31, 2007, we expect that the effective tax rate will be higher for the remainder of fiscal year and will remain so until the credit is reinstated. We expect the effective tax rate will approximate 36% to 37% in both the fiscal third and fourth quarters and thus approximate 35% to 36% on a blended basis for the full fiscal year.

As Orrin mentioned, we achieved 60% increase in cash flow from operations in the December 2007 quarter. This increase was driven by growth in net income and higher year-over-year depreciation and non-cash expenses partially offset by the quarterly change in operating assets and liabilities.

Despite the growth in revenues, we were able to lower our inventories by nearly $7 million from September 2007, but this is offset by $19 million increase in accounts and notes receivable largely related to a higher than expected sales increase late in our quarter and the $6 million increase in restricted cash partially related to our increased installed footprint of WAP participation gaming machines.

During the quarter, we continued to achieve success in raising the return on capital played in our gaming operations business. In the December 2007 quarter, we invested $14 million in gaming operations equipment, down from $18 million deployed in the December 2006 quarter, although that is only part of the story.

Capital expenditures for gaming machine additions in fiscal 2008 year-to-date totaled $29 million, down from $32 million invested in the first six months of fiscal 2007. However, so far in fiscal 2008, our total installed base is up 910 units or an increase of 11%, more than double the 328 units or 5% increase for the first six months of last year.

In addition, we are realizing an increase in average daily revenue, up 6% on average for the first six months for fiscal 2008 over the first six months of fiscal 2007. And again in the December 2007 quarter, as in the September 2007 quarter, capital expenditures for gaming operations equipment were less from the depreciation associated with our gaming operations business.

Overall, total cash increased to $82 million even with our $10 million share repurchase activity during the quarter. Let me outline our priorities for utilizing this improved cash flow. As most of you know, our first priority is to continue to emphasize internal and external investments to create or license advanced technologies and intellectual property for future new and innovative gaming products and applications.

In the December 2007 quarter, our R&D spending increased $3 million over the prior-year quarter. Additionally, we invested $5 million in investments and advances in royalties, technologies and brand licenses.

I believe our past record in the innovative products, applications and services we demonstrated at G2E offered clear evidence that by investing in these opportunities, we generate the highest return potential for WMS and our ability to continue creating sustainable stockholder value.

In addition we continue to pursue acquisitions that can extend our international presence and important intellectual property and technologies or expand earnings potential, although we did not announce or close on any M&A activity in the December 2007 quarter.

We repurchased 306,100 common shares in the December 2007 quarter at an average price of $32.61 for a total of approximately $10 million. With the growth potential that lies ahead, including visible demand from new and expanding jurisdictions worldwide, the anticipated acceleration of the domestic replacement cycle and the expanded revenue opportunities from server-enabled gaming, we believe such share repurchases will prove to be an attractive use of capital.

Looking forward in conjunction with our ongoing pursuit of IP and attractive acquisitions, we'd also expect to opportunistically make additional share repurchases under the remaining $40 million authorization that the Board has provided.

And with that, let me turn the call back to Brian for final comments.

Brian Gamache

Thank you, Scott. As discussed in our press release, we increased our revenue expectation for fiscal 2008 and initiated our third and fourth quarter revenue guidance.

This new revenue guidance anticipates sales for the new Indiana racinos and the expansion in California at those Native American tribal casinos that have capacity within their existing facilities, none of which were assumed in our original guidance.

The impact of the additional revenues is tempered by our expectation for continued softness in North American replacement demand and the impact of a slower economy. The net impact of these additional new units coupled with the better than anticipated growth in our gaming operations business results in raising our revenue guidance for fiscal 2008 to a range of $620 million to $632 million.

In addition, we are initiating a range of $160 million to $166 million revenues for the third quarter, which implies fourth quarter revenues in the range of $168 million to $174 million. This represents revenue growth in the second half of 11% to 15% over last year.

I'll remind everyone that this expected strong second half growth is anticipated despite the ongoing challenges presented by the store replacement cycle. With wonderful opportunities for sale to new or expanding jurisdictions and improvement in the domestic replacement cycle and the advent of new revenue streams made possible in the network gaming environment, we clearly believe that the best days WMS are ahead of us.

And I hope that today's call next call provided further insights on how we are positioning the company for sustainable near, medium and long-term growth.

We were excited about the opportunity to bring our customers the many new benefits of server-enabled gaming environments, which we expect will also further accelerate the replacement cycle in the near future.

As you can extrapolate from our increased R&D activities and the visionary prototype products and applications previewed at G2E, our team has a deep and diversified pipeline of offerings that are broadening our portfolio while providing WMS with new and expanded revenue streams in the years ahead. So, it goes without saying that we're privatizing our resources to accelerate efforts to bring these products and applications to market in the near immediate term.

As a result, we are now expecting our R&D expenses to approximate 12% of revenues for fiscal 2008 with the expectation that the run rate will continue at a similar rate extending into fiscal 2009. We believe such investments in our future are the best way to maintain sustainable profitable growth and increased shareholder value.

In aggregate, we continue to expect the ongoing improvement in our operating margin, and we will still anticipate that operating margin will be in the previously announced range of 15% to 16% for fiscal 2008.

As we look ahead, new casinos, additional new jurisdictions and casino expansions offer substantial potential for the further expansion of gaming worldwide. These include Kansas, Massachusetts, Maryland, Kentucky and our home state of Illinois. Opportunities in Florida with the Native American tribes in Dade County as well as the continued expansion of Pennsylvania and the ongoing transition of Oklahoma coupled with substantial international opportunities.

I would also like to note that our strategy to accelerate the resources devoted to capitalizing on expanded revenue opportunities will in no way detract from our focus on improving operating efficiencies and building customer touch points.

From taking a customer order to a priced production and installation, we are vigorously engaged in improving our business processes to further drive margin enhancement and accelerate our order to delivery timeframe, while simultaneously ensuring we offer the highest quality products in the industry.

In closing, let me summarize the significant factors that support our optimism for the remainder of fiscal 2008. First, our new products started very strong and positive response at G2E and ICE and at the many customer meetings and events that we have conducted over the past few months.

Specifically, the strong demand for our existing products and customer excitement about products being launched in the second half of the year are great indicators of our upcoming success.

Second, our substantial and differentiated pipeline of innovative products and applications under development, all of which utilize our advanced technologies and intellectual property. There is no doubt that innovation is essential to our continued success in gaining market share, and WMS in well positioned to drive the adoption of the next generation of gaming products and services.

And lastly, WMS's culture and organization is demonstrating not only its ability to create innovative new products, but also its dedication and adaptability to accept the mindset in business process tools to drive operating improvements that create margin expansion and enhance cash flow generation.

With WMS's team, the foundational competitive strengths that we have in place today, we are excited by the opportunities and potential for growth and profitability in the coming years.

Now, we'll be happy to take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Joseph Greff with Bear Stearns.

Joseph Greff - Bear Stearns

Hi, guys, good afternoon.

Brian Gamache

Hi, Joe.

Scott Schweinfurth

Hi, Joe.

Joseph Greff - Bear Stearns

With respect to your commentary on your revised fiscal '08 outlook, you referenced the California casinos. What sort of ship share are you baking into that?

Brian Gamache

Well, right now, we believe there is going to be about 5,000 units in the neighborhood, to be delivered during our fiscal '08, which will end June 30th, and the remainder will be delivered in the fiscal '09 and '10. Today's guidance reflects these initial places primarily in the Q3, and then some trickling into Q4.

Of the four orders that we have in hand, we believe our branded market-share to be in the mid-20s, actually 23% for the four orders that we have garnered thus far.

Joseph Greff - Bear Stearns

Great, excellent. And in the quarter, you recognized the revenues from Palazzo, what was your ship share, market share there?

Brian Gamache

I believe we have a total share on that floor of 17%, which is the highest strip-market share we've ever had in an opening. We're starting to get some serious traction on mechanical products. And I think as you see our continued success, I believe we shipped actually 30% of our products in this quarter were mechanical reels. And as you see that continued success, we'll continue to evolve our market-share growth in the strip properties.

Joseph Greff - Bear Stearns

Great. And then with respect to how you view the opportunity with the [Seminole], but I think you participated in the initial order. Can you talk about how you view that?

Brian Gamache

Sure. Actually, we just had a meeting there yesterday, and we believe that we are in final stages of negotiating a sizable order, which will be shipped during our Q4. These games are a combination of participation, WAP and the traditional for-sale games, and they'll be placed on a lease basis for multiple years. These placements will have a modest impact on Q4, but will really give us a major shot in the arm heading into '09.

Joseph Greff - Bear Stearns

Great. And then my final question here: With regard to your updated guidance on the average installed base of participation games that increase relative to your prior guidance -- can you help us explain what's driving that? Are you adding more games, or is it the same amount of games that you thought you were going to add before, but it's just kind of less removals? How do you look at that?

Brian Gamache

I think it's a combination of both, Joe. We're having less removals, and the games are staying out there longer, and we've had a great success with the launch of our latest three platform.

So, I think what Orrin said in his comments were, you won't see the continued growth in the Q3 because we're launching two significant products in Q4. So, Q3 is really meant to kind of stabilize the footprint and then reallocate those assets as Q4 launches come to make sure we got the lower-performing games in the higher-performing units in Q4 and beyond.

Joseph Greff - Bear Stearns

Great -- thanks, guys.

Operator

We also have a question coming from the line of Steve Kent with Goldman Sachs.

Steve Kent - Goldman Sachs

Hi, good morning. Could you just talk about the conversion kit sales? How should we think about them? They continue to be better than expected. Are they taking any future sales away? How are you viewing them on an ongoing basis?

And then on the SG&A, could you just go into a little bit more detail on that as to what the issue is there, and longer term, what should that SG&A grow at or what should it be as a percentage of sales?

Brian Gamache

Okay, let me take it first and first. The fact that we have a higher conversion rate of revenue, Steve, is a good thing. That means our products are working, and people want to keep their floor fresh with WMS's newest themes. So I would look at that as a positive, because when the cycle comes for the operator to buy new games, our earnings are going to be at the top of list. And that's typically how they judge their capital allocation.

So, it might be a little bit of a negative in the short term. In a long term, we will continue to build goodwill of our customer, and we would view that additional revenue in that area as a very positive momentum, because our themes are working.

On the second piece, SG&A, if you break down, there was really four major components to the overage in this quarter. And that is, as Scott mentioned, the catch-up on the long-term incentive plan, with a portion of which is a one-time event. We had additional legal fees. We are in litigation with our insurance carrier over the hurricane Katrina, and that's coming to trial this year, and that's mounting.

We had a little bit of a bad debt based on the volume. We wanted to make sure that we had significant approvals there. And also the increased payroll costs due to the additional volume in the customer touch points. So, on a going-forward basis, we would expect a slight decrease for the second half of the year. And then next year, it will decrease as a percentage of revenues over today's position.

Steve Kent - Goldman Sachs

Just on the bad debt, that's the one I don't fully understand. What's the issue there? As you grow, you're increasing your bad debt numbers, or is there something specific there to the new type of customers you are taking on?

Scott Schweinfurth

Steve, this is Scott. Every quarter, we look at what we have in our receivables, and we have to adequately provide for those accounts that we don't believe we're going to be able to collect on.

And this quarter, you can see from the cash-flow statement, because we've disclosed a lot of that provision there, we recorded a bit more than we had in the prior year.

Brian Gamache

It's primarily volume-related, Steve.

Steve Kent - Goldman Sachs

Okay, great. Thank you.

Operator

And we also have a question from the line of Harry Curtis with JPMorgan.

Unidentified Analyst

Hello.

Brian Gamache

Hi.

Joe Herrick - Gutterman Research

Actually, this is [Joe Herrick with Gutterman Research]. A couple of things, Brian. I'd say congratulations on great results. You always come through in a very accounting time. You were talking earlier regarding Lean and Six Sigma initiatives. What are going to be your operational initiatives revolving around Lean and Six Sigma in your plans? And how do you plan to improve group (inaudible)? What benefits you're going to be seeing within that?

Brian Gamache

Patty Barten and her team of people have really pushed [beyond well] period in the last 18 months, and you've seen dramatic margin improvement on a gross-product margin going from the low 40s to high 40s now.

As we said on our last call, we would be disappointed if we didn't get our five handle in front of the gross margin and product sales sometime in this fiscal year, probably Q4. So, we've made dramatic improvements in the last 18 months. We continue to look at -- continued improvements throughout entire organization following this very, very knowledgeable team of people that are leading us from their efforts.

So I would expect you'll see continued margin improvement. That's a very important obstacle or challenge that we're addressing here internally. We think we made great progress and more to come.

Joe Herrick - Gutterman Research

What metrics are you guys looking in your manufacturing side? Are you looking at RONA, which seems to be very common right now or OEE? How are you guys measuring yourselves in terms of overall throughput?

Brian Gamache

We're not going to disclose that publicly, but we have many, many metrics that we deal here with internally, and we manage it on a very course basis day-by-day.

Joe Herrick - Gutterman Research

Okay. And going forward into 2008, what sets of inclusions are you putting up in place to accelerate in these improvement initiatives to stay competitive in the market?

Brian Gamache

Again, we will continue to address these operating margin improvements on the quarterly calls. But for competitive reasons, we don't feel it's appropriate to break those up publicly.

Joe Herrick - Gutterman Research

Okay. Would you like to tell the shareholders about how you plan to keep the stock price going up, including the overall cost affecting us?

Brian Gamache

Well, I think when you look at our track record here for the past two years, we've proven that we know how to operate in the best of times, in the worst of times. And I think that when you look at the fact that we're able to grow our revenues, our profits, our cash flow, our margins throughout probably the most challenging environment in the last several years, I think that our records speak for itself.

Operator

And our next question comes from the line of Bill Lerner with Deutsche Bank.

Bill Lerner - Deutsche Bank

Hi, guys.

Brian Gamache

Hi, Bill.

Bill Lerner - Deutsche Bank

Two questions: one, about free cash flow or cash from ops, maybe for Scott or Brian? You guys I think will be close to $70 million or a little more than $70 million for the first fiscal half of '08, and I would suspect you'd run rate little more than [2X] that for the full year, yet a little bit, relatively speaking, left in the buyback.

When do you get more aggressive? Obviously, you'll be strategic about it, because you don't want to do it after the stock you'd perceived might run in conjunction with the beginning of SBG and all that. But I still want to get the sense of use of cash? And then I've got a follow-up.

Brian Gamache

I think when you looked at Scott's comments, Bill, you were really looking at using our assets under a variety of front, particularly growing our business. We are looking at intellectual property and licenses and technology that doesn't come without an expense.

So, we are continuing to invest in building this company. We will always look at share repurchases in a normal course of our business day, and we will from time to time jump in when it's appropriate.

So, as we have indicated last quarter, we bought $10 million worth of a $32 point of average, and we believe those are great purchases, and we have bought $65 million of stock since 2002 at $13 average point, I believe. So, we have proven we can buy the stock effectively. We will continue to look at doing so and deploying the assets of the company where we think it's the best return for the shareholders.

Bill Lerner - Deutsche Bank

Okay. Thanks, Brian. And I still have a follow-up actually for Orrin. Orrin, can you just talk for a second about on the SBG front? What your sort of integrated offering is? I think the general view has been that you won't have a central server or a casino controller whatever you want to call it. But you would have, of course, sub-servers with content boxes to sell in. So, could you just talk a little bit about where we might have misperceived?

Orrin Edidin

Bill, it's really a fully comprehensive approach. In fact, our field trials will contemplate this, so that our turnkey solution, including servers for basic functionality, including remote config and download, et cetera. We are looking at from a strategic standpoint, and more of the application level in terms of driving-game enablement, higher earnings for the casino floor as well as the basic functionality that will drive the higher-cost saving efficiencies at the primary server level.

So, really depending on the market, depending on the customer, we intend to be able to offer a full range of solutions, everything from primary servers to sub-servers and game applications for yield management, et cetera. So, it really covers the gamut.

Bill Lerner - Deutsche Bank

So, how do we think about this? So, if one or two initial casinos come along and it's one of your competitor's central servers, because it's open protocol, you'll be able to play regardless whether it's your central system or not right?

Orrin Edidin

That's correct. And having submitted the first fully GSA-compliant server-based system, we're fully prepared to be interoperable with all the major manufacturers, both at the system level and the game level. So, we think we're pretty well positioned as we start to make penetration into that market as against traction.

Bill Lerner - Deutsche Bank

Yes, that's great. Thanks, Orrin. Thanks, guys.

Operator

And our following question comes from the line of Kent Green with Boston American Asset Management.

Kent Green - Boston American Asset Management

Yes, just a quick question on the taking back up the license agreement in Australia and New Zealand. Is it difficult? Have you disclosed anything about the units that they were participating in and how long will it take to ramp up your own operation, particularly with your intellectual property or group in Sydney?

Scott Schweinfurth

We think the royalties we're generating of our server are relatively modest. We think the real opportunity, as you point out, is direct participation in that market as well as leveraging the talents of our very skilled game studio in Sydney to look at themes that we commercialize around the world. So, we are seeking to enter that market directly. And from a timing standpoint, looking at platform and cabinet approvals, 12 to 24 months would be about the expected timeline.

Kent Green - Boston American Asset Management

And then just a quick follow-up question. A lot of people have discussed that the Nevada-based gaming operations have been slowing more rapidly with the economic proceed slowdown. Your jurisdiction is away from Las Vegas. So, have you noticed that in, say, participation game or average plays or anything else that you do think that that will continue?

Brian Gamache

Our December quarter and our January rates, Kent, win-per-day rates would not indicate there is a slowdown as of this time. Now, it doesn't mean it's not going to come. But right now, we're not seeing any softness in the economy as it relates to our gaming operations.

Kent Green - Boston American Asset Management

And you'd been most doubtful historically about -- you don't talk about market share. Is there any kind of update in market share? I know you gave some numbers, but also some of the others ones. Is that pretty standard? And then on strip-based casino mega hotels, do you normally start off with a lower base historically and then start to build?

Scott Schweinfurth

As I said on the question originally, our 17% market share at the Palazzo is the highest we've ever had on the strip property. We typically are in the single-digits in the 8% to 10% range.

And now going forward, we would expect, because the success we're having with our mechanical reel products that we'll get closer to our normal market share, which we believe today our ship share is somewhere in the early 20s, 22, 23 -- ship share is typically what we would expect.

Again, we can't give you market share information today, because some of our competitors have yet to report, and I believe that that will come out from the analyst community in the near future.

Kent Green - Boston American Asset Management

Thank you.

Operator

We also have a question coming from the line of David Katz with Oppenheimer.

David Katz - Oppenheimer

Hi, good afternoon.

Brian Gamache

Hi, David.

Scott Schweinfurth

Hi, David.

David Katz - Oppenheimer

Most of mine have been addressed, but can you talk a little bit about -- and I apologize if I missed it, but the domestic unit sales, how many of those sort of replacement of your units versus replacing somebody else's? And the degree to which you can talk about that is something we're trying to track carefully, replacement activity.

Brian Gamache

We don't really track that information, David. When we sell the game to the operator, it's really his asset to either sell to a second party or whatever, but we don't really track that information. We really focus on ship share amongst our competitive set.

David Katz - Oppenheimer

And how about the amount or the number of your own older product out there that may be on older platforms that you might be keeping an eye on as potential for you to replace yourselves in the future?

Brian Gamache

We've been now at this re-emergence for three-plus years. And we believe there are a few thousand, call it 3,000 to 5,000, units still out there, and we are tracking them down as we speak to try to replace those during this challenging time. But a lot of the operators are not anxious to trade it, because it's still performing at a high level, and a lot of the operators' games are still out there.

They bought the transition program to CPU-NXT, the conversion kit, and then the games were performing quite well for them. So, again, we have gone through most of the 50,000 units that we had to address when we first reemerged, and we are now just left with a few thousand.

David Katz - Oppenheimer

So fair to say anything you are replacing or selling, anything older than four years old, isn't yours. You'd be effectively replacing somebody else's?

Brian Gamache

We have spent about 75,000 units out there since we have reemerged. So, we are getting some market-share traction. There is no question. That's the question.

David Katz - Oppenheimer

Yes, nice job, guys.

Brian Gamache

Thank you.

Operator

Our next question comes from line of Celeste Brown with Morgan Stanley.

Celeste Brown - Morgan Stanley

Hi, guys, good afternoon.

Brian Gamache

Celeste.

Scott Schweinfurth

Celeste.

Celeste Brown - Morgan Stanley

First, on the international side, I know you started launching your platforms on a global basis, so you could sell international games domestically and internationally at the same time. What kind of benefit do you think you are getting from that, as you have got the older machines that hadn't been introduced at the same time sort of selling maybe twice as many games into that market?

Orrin Edidin

I believe there has been a tremendous boost to our revenue stream, and the fact is we can now do instantaneous translations when you start to go back and re-spin the games in individual languages, which would take us forever. And if we took a new game out in North America, it might take 18 to 24 months by the time we get through all the jurisdictions to get it promote it worldwide. So, now it's instantaneously released worldwide, and it's proved to be a huge asset particularly in the fact that our G+ games are doing so well internationally, and we can't keep them in stock over there. So, it's a tremendous asset to us.

Celeste Brown - Morgan Stanley

But in terms of is there a catch up with some of the older games that sort of predated this instantaneous release on top of the sales are getting from the instantaneous release and that will anniversary itself, I think?

Scott Schweinfurth

I think sort of similar question of previous call I think that there is an opportunity for us to replace a lot of legacy games over there. That's being, again there is a lot of international jurisdictions that previously we had not served. And we are now expanding our sales force, which has been dramatically enhanced over the last couple of years, and we've got Orion now, so we're in more places with products that serve those markets very well. So, I think it's a combination of greater distribution capabilities and products that matches the various international jurisdictions.

Celeste Brown - Morgan Stanley

Okay. And then, I was -- in your comment…

Scott Schweinfurth

Let's add one more thing.

Celeste Brown - Morgan Stanley

Yes.

Scott Schweinfurth

We've said in the last call, and I feel strongly about this, that we would be looking to have 50% of our box sales over the next several years come from the international arena. We think that is going to continue to grow. Our presence there is going to expand, and to that point, we recently promoted Sebastian Salat to President of WMS International because we want to continue to develop our presence worldwide to make business decisions and strategy decisions for the international markets locally.

Celeste Brown - Morgan Stanley

I guess that leads into my next question, which is, I mean, when do you think the domestic-replacement cycle will start to improve? Are there any signs out there, or is it continued to and as you look into the future, it still continues to look pretty drop?

Brian Gamache

Well, again, I think that we're seeing some signals. I think getting some of these private equity transactions closed and put behind us will be very important part of that turnaround. But I think we will see that in our calendar '09 going into our last half of our fiscal '09, we'll start to see the turnaround.

Celeste Brown - Morgan Stanley

Okay.

Brian Gamache

Based on all the customers we talk to.

Celeste Brown - Morgan Stanley

And then finally, you mentioned in your press release, and then on the call, that your guidance reflects the anticipated impact from a slower economy, yet you mentioned that you're not seeing any softness in the participation or your game-ops side of the businesses. Are you anticipating something or just sort of factoring that in the game ops, or are you expecting a slowdown in terms of box sales because of the economy?

Brian Gamache

The answer is yes. We're trying to be realistic in our approach to providing guidance. I know, you know, this, but we've been six quarters in a row now spot on our guidance, that's important to us. And so, we're taking a realistic approach, a cautious approach perhaps because we believe that the economy is going to be affected somewhat and we want to make sure that we're not over-promising and under-delivering. So, I think that we've got a guidance number out there that we are very comfortable with, and we feel it's very realistic.

Celeste Brown - Morgan Stanley

So, does your guidance reflect lower sales, or is it just on the game ops side?

Brian Gamache

It's primarily in the gaming-ops side because again, we've had a tremendous growth there. And we don't anticipate that business continue to roll as aggressively as it has for the past few quarters, although Q4 should see a nice uptick with the launch of two fabulous products that we are bringing to the market.

Celeste Brown - Morgan Stanley

Great, thank you.

Operator

Now, our next question comes from the line of Todd Eilers with Roth Capital.

Todd Eilers - Roth Capital

Hi guys, thanks for taking my call. Just a couple of quick questions. First, just a follow-up on the guidance. You guys talked a little bit about the potential deal coming with the Seminoles, which would be looks like recurring revenue placements for you guys. And I don't know if I heard you right is that deal included in your guidance in your recurring revenue installed base or would that be upside?

Brian Gamache

No, the deal is still being negotiated, so we don't put the current negotiations into our guidance. Although, it will be a minor part of our uptick in gaming operations revenues in Q4.

Todd Eilers - Roth Capital

Okay.

Brian Gamache

But going into fiscal '09, we'll clearly delineate the kind of numbers that we're talking about going forward.

Todd Eilers - Roth Capital

Okay, that's my only question. Thanks guys.

Operator

We also have a question from the line of Steve Altebrando with Sidoti.

Steve Altebrando - Sidoti

Hi, guys.

Brian Gamache

Hi, Steve.

Orrin Edidin

Hi, Steve.

Steve Altebrando - Sidoti

I had a couple of quick questions on the international side -- it seem like a real point of strengthened, is it more related to the Orion games branded games, or WMS branded, or a mix of both?

Scott Schweinfurth

Right now Orion is in a transition between its Legacy platform and its new Twinstar platform that we launched last week at ICE. So, the Orion results aren’t nearly as impressive as they were a year ago because they are in between kind of we were before we came out last CPU-NXT Platform.

But that being said, the WMS games have got tremendous traction over there, and it's in the areas of the international arena that we really hadn’t pursued up until over the last call 12 months. So, I think, when you look at a 47% increase in year-over-year revenues, we are starting to hit on all cylinders. What I'm really excited about is, we've gaming ops, we've international. We're not necessarily reliant on the North American marketplace anymore for our revenue growth. And the fact that, we are able to grow our revenues 18% as a company in the most difficult times, I'd say that that bodes well for us going forward.

Steve Altebrando - Sidoti

Is there any region you could point to where you are seeing most of this growth or is it across the board?

Scott Schweinfurth

Sure. I think in Orrin comments he mentioned its Asia, Latin America and Western Europe.

Steve Altebrando - Sidoti

Yeah.

Scott Schweinfurth

So, I think that those are the strongholds right now. But we're doing well in other areas of the world in addition to those three.

Brian Gamache

And just last sort of point, the simultaneous release of themes on a global basis really give us a leg-up to address the international market simultaneously with one coordinated launch.

Steve Altebrando - Sidoti

Okay. And the last one I had is internationally do you see a gaming-ops opportunity, I know for the most part domestically now do you see that lot of potential?

Scott Schweinfurth

Unfortunately either jurisdictions don’t allow it. We would like to have gaming operations internationally -- it’s a very profitable part of our business. But I'd not expect I wouldn’t pull with my model put it that way.

Steve Altebrando - Sidoti

Okay, thank you, guys.

Operator

Our next question comes from the line of Steven Wieczynski - Stifel Nicolaus

Steven Wieczynski - Stifel Nicolaus

Hey, good afternoon, guys.

Brian Gamache

Hi, Steve.

Steven Wieczynski - Stifel Nicolaus

A question for Brian or Scott, just one question here. As we now move three months from G2E, as you guys kind of look back and as you walk the floor and talk to operators, what would you say was the biggest pushback you got from the operators in terms of your SPG product obviously minus the economic uncertainty?

Brian Gamache

Orrin, do you want to take that one?

Orrin Edidin

Well, I think for because the WMS was really emphasizing interoperability and demonstrating how we can use the network environment to drive the revenues of the game and the game-enabled insight. We had a tremendous reception.

To an extent we heard off -- to an extent there was any disappointment, perhaps it was on lack of clarity of pricing models then perhaps some of the customers were expecting to receive last November. I think they will get greater clarity in that from all of the majors as we get closer to the commercialization of those products. But to the extent that I'd call it pushback more or less disappointment was in fact they might have been expecting greater clarity on pricing.

Brian Gamache

I'd agree that. Well, the customers I talk to expect that the commodity with the bundle packages how this is going to work, and they didn't necessarily receive that.

Steven Wieczynski - Stifel Nicolaus

Okay, great. Thanks, guys. Good quarter.

Brian Gamache

Thank you.

Operator

And Mr. Gamache, I'll turn the call back to you.

Brian Gamache

Great. Well, thank you very much for joining us this afternoon. We look forward to reporting our additional progress on our next call, when we'll discuss our fiscal third quarter results. Have a great afternoon.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask you please disconnect your lines.

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Source: WMS Industries Inc. F2Q08 (Qtr End 12/31/2007) Earnings Call Transcript
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