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International Game Technology (NYSE:IGT)

F2Q08 Earnings Call

April 17, 2008 9:00 am ET

Executives

Patrick Cavanaugh - Investor Relations

Thomas Matthews - Chairman, President, Chief Executive Officer, Chief Operating Officer

Danny Siciliano - Chief Accounting Officer

Analysts

David Katz - Oppenheimer

Steve Kent - Goldman Sachs

Joe Greff - Bear Stearns

Steve Wieczynski - Stifel Nicolaus

Celeste Brown - Morgan Stanley

Bill Lerner - Deutsche Bank

Robin Farley – UBS

Amir Markowitz – JP Morgan

Operator

Welcome and thank you for standing by. (Operator Instructions) I would now like to turn the call over to Pat Cavanaugh, Vice President of Corporate Finance & Investor Relations. Sir, you may begin.

Patrick Cavanaugh

Thank you, operator and good morning. Welcome, everyone to IGT’s second quarter fiscal 2008 earnings call. Joining me today are T.J. Matthews, our Chairman and Chief Executive Officer; and Danny Siciliano, our Chief Accounting Officer and Treasurer.

Before we begin, I’d like to note that during this earnings conference call certain statements and responses to questions may contain forward-looking information, including forecasts of future financial performance and estimates of amounts not yet determinable; the potential for growth of existing, and the opening of new markets for our products; play levels for our install base of recurring revenue games as well as our future prospects and proposed new products, services, developments or business strategies. Actual results could differ materially from those projected or reflected in our forward-looking statements. Already reported results should not be considered an indication of future performance.

IGT’s future financial condition and results of operations as well as its forward-looking statements are subject to change and to inherent known and unknown risks and uncertainties. IGT does not intend and takes no obligation to update our forward-looking statements, including any comments regarding our earnings expectations to reflect future events or circumstances.

All forward-looking statements made in this conference call reflect IGT’s current analysis of existing trends and information and represent IGT’s judgment only as of today. You should not assume later in the quarter or the year that the comments we make today are still valid.

Actual results may differ materially from the current expectations based on a number of factors affecting IGT’s businesses, including: unfavorable changes to regulations or problems with obtaining or maintaining needed licenses or approvals, a decrease in the popularity of our reoccurring revenue games or unfavorable changes in player or operator preferences or a general decline in play levels; decreases in interest rates, which in turn increase our cost of jackpot; slow growth in the number of new casinos or the rate of replacement of existing gaming machines; and failure to successfully develop and manage frequent introductions of innovative products.

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

During this call today references may be made to non-GAAP financial results. Investors are encouraged to review these non-GAAP financial measures as well as the reconciliation of these measures to comparable GAAP results in our 8-K filed with the SEC today; a copy of which can be found on our website at IGT.com.

This call, the webcast of this call and its replay are the property of IGT. It is not for rebroadcast or use by any other party without the prior written consent of IGT. If you do not agree with these terms, please disconnect now. By remaining on the line, you agree to be bound by these terms.

With that said, today we reported results for the second quarter of fiscal 2008. Net income in the second quarter totaled $68 million or $0.22 per diluted share compared to $128 million and $0.38 per diluted share in the prior-year quarter. Included in the quarter were a number of significant financial items which negatively impacted our results. These items totaled $20 million after tax or $0.06 per diluted share.

Last year’s second quarter saw significant items which increased net income $17 million after-tax or $0.05 per diluted share. A comparative schedule detailing the items affecting the quarter and last year’s second quarter is included in our earnings press release which we issued earlier this morning. I will give more detail on the items in my forthcoming discussion of our business.

First, gaming operations. Our gaming operations business generated revenues of $341 million in the second quarter. Revenue on a quarterly basis was up 3% sequentially and flat with the same quarter last year. Our install base ended the second quarter at 58,700 units and earned $64 in revenue per unit per day compared to 54,800 units and $69 in revenue per unit per day in the last-year quarter.

The decline in revenue per unit year over year is mostly due to the growing mix of lower-yielding units and to lower play levels given the current operating environment.

On a sequential basis, the 3% increase in yield to $64 from $62 in the first quarter is primarily attributable to seasonality, as our second quarter usually sees an uptick from our seasonally slowest first quarter. Historically, our second quarter has shown an average yield growth of 6% to 8% compared to the first quarter due to seasonal play level improvements. The underperformance in the most recent quarter we believe to be the result of lower play levels given the current operating environment as well as shifts in our product mix.

Going forward, we anticipate that yields will be between $64 and $66 per day, with the caveat that yields will continue to be subject to the current operating environment. Placements were up 3,900 units over the prior-year quarter but off slightly at 100 units. In the casino operations sector of our installed base we ended the quarter at 39,700 units, up 1,600 over last year’s second quarter and down 800 sequentially from the prior quarter. The increase over the prior year was generated by additions in Oklahoma and Florida, while the sequential reduction was primarily the result of the transition away from Class II and into for-sale Class III units in both Florida and California.

In the lease operations sector, our installed base totaled 19,000 units, representing growth of 2,300 units year over year and 700 units sequentially. Mexico made up the bulk of the year-over-year growth, while growth in Delaware and the UK contributed to the sequential increase.

Gross profit on gaming operations totaled $184 million for the quarter, down from $211 million in the prior-year quarter. Gross margins were 54% for the quarter, down from 62% in the prior year, with most of the decrease attributable to significant items. Margins were reduced by unfavorable jackpot expense as a result of the 200 basis point drop in the prime rate during the quarter. The margins for the quarter were also affected by other significant items, with current quarter technological obsolescence charges related to the transition toward our innovative new cabinets and platforms as well as last year’s benefit from the hurricane property insurance proceeds. Adjusting for these significant items our Q2 margins would have been approximately 60%. The remainder of the reduction in margins was mostly due to lower play levels.

While our gaming operations’ margins are negatively impacted by lower interest rates, on a whole IGT is somewhat mitigated or hedged as we incur lowering borrowing costs when rates are declining. However there’s a 60 to 90 day lag due to the timing of rate adjustments on our line of credit, so we were not able to realize this benefit during the second quarter.

Taking into account lower interest rates and current market expectations for rates, game ops gross margins are projected to trend within a range of 57% to 60%, with fluctuations based on the timing of jackpots, interest rates and the mix of games in our install base. We expect the install base to resume growth in the second half of ‘08 and beyond as new expansion opportunities begin to open and we expand our footprint in Florida, Alabama, and Oklahoma.

Now moving on to product sales. Product sales revenue totaled $232 million for the quarter compared to $269 million in last year’s second quarter. Worldwide we shipped 12,100 machines in the second quarter, down 35% from prior-year quarter shipments of 18,800. As expected, the second quarter saw continued low levels of marketplace demand and minimal new capacity added. Non-machine revenues comprised of gaming systems, game theme conversions, table parts and intellectual property fees came in at $87 million for the quarter or 38% of total product sales for the quarter compared to $90 million and 33% of total product sales in the prior-year quarter. Average revenue per unit for the year was $19,200 compared to $14,300 in the prior year. The 34% increase was driven by increased share of revenues from non-machine sources and reduced demand in lower-priced machine markets of Japan and the UK.

Product sales gross margins were 55%, up 100 basis points from the prior-year quarter, due to favorable product and jurisdiction mix and fewer machines having been shipped into Japan and the UK.

For the second half of fiscal 2008 we expect product sales margins to trend between 49% and 52% as new and expansion openings and the rollout of new IGT products drive increased box demand. As IGT realizes additional box demand relative to non-box revenue, our mix will result in lower margin percentages.

Breaking product sales down domestic versus international, first domestic, product sales revenue totaled $148 million on volume of 6,500 units for the current quarter, compared to $181 million and 9,700 units in the prior year quarter. Domestic replacement shipments totaled 4,300 units for the quarter, down from 6,400 units in last year’s quarter and up from 3,200 in the immediately preceding quarter. As expected, new unit shipments were 2,200 units for the quarter, down from 3,300 in last year’s quarter and down from 4,200 in the immediately preceding quarter.

Domestic non-machine revenues totaled $67 million in the quarter, down 6% on a year-over-year basis. The decrease was the result of lower systems revenues, which fluctuate from quarter to quarter depending on the timing of installations. Domestic average revenue per unit was $22,800 compared to $18,600 in the prior-year quarter. Sales of machines utilizing our AVP platform reached 57% of total North American machines shipped during the second quarter.

We are devoting more resources towards this platform, including creating more exclusive game content. Because AVP machines have a higher price point than our legacy platforms, we expect to see higher average sales prices in the future.

For the second half of the year, we anticipate replacement demand to begin to pick up as we release our latest products, including six new cabinet designs utilizing the AVP platform. New unit demand should also reaccelerate in the second half of 2008 due to scheduled openings of new and expansion projects.

Moving on to the international product sales, revenues were a total of $84 million on volume of 5,600 units, compared to $88 million and 9,100 units in the prior year quarter. The quarter saw continued minimal levels of unit shipments in the lower-priced markets of Japan and the UK, which combined were down 2,800 units from the prior year. Our international casino market saw slightly lower units sold coming off record levels seen in the first quarter.

International non-machine sales were $20 million, up 7% over the prior year. International average revenue per unit totaled $15,000 up 55% over the $9,700 realized in the prior year quarter. The ARPU increase was driven by fewer lower-priced machines shipped into Japan and the UK, a higher contribution of non-box sales, and favorable exchange rates.

As we expected, international operating income for the quarter was down 60% sequentially and 15% compared to last year’s quarter, coming off the immediately preceding quarter. We anticipate international results to reaccelerate off the lower volumes of traditional slow second quarter of the fiscal year. We also saw a number of sales originally projected for the second quarter shift into the second half of 2008.

Despite this, our international unit achieved record results for the first half. These operations will continue to see results fluctuate from quarter to quarter depending on geographic mix of sales but should continue to increase their contribution to our consolidated business as we continue to believe that at some point in our future the contribution from our international business will exceed that of our domestic business.

Now moving on to operating expenses, total operating expenses were $184 million for the quarter compared to $154 million in the prior-year quarter. SG&A inclusive of bad debt totaled $112 million, an increase of $24 million over Q2 of 2007, mostly due to a number significant items. Last year’s quarter included business interruption insurance proceeds related to Hurricane Katrina of $12 million and a gain on the sale of the corporate aircraft of $6 million.

Professional services increased during the quarter, as submission efforts and costs increased in order to roll out our new products in the future. Bad debt provisions totaled $6 million in the quarter, compared to a $4 million credit in the prior-year quarter. Excluding bad debt and other significant items, SG&A was flat year over year.

R&D expense totaled $54 million for the quarter, up 13% over the prior-year quarter, as we continue to invest more heavily in future product innovations in SB. Depreciation and amortization within operating expenses totaled $19 million for the quarter. Depreciation and amortization inclusive of depreciation on game ops machines was $77 million from the quarter, up from $66 million in the prior-year quarter. The increase was driven by the 3,900 unit growth in the game ops install base compared to last year’s second quarter.

For the remainder of fiscal 2008, we anticipate our total operating expenses return to a range of between 26% and 28% of total revenues, driven by the anticipated ramp up in product sales.

Other income and expense net was an expense of $9 million for the quarter, compared to other income net of $2 million in the prior year. Higher other expense was mostly due to higher interest expense related to additional borrowings on our line of credit as well as reduced interest income on lower corporate investments.

Tax rate during the second quarter, our tax rate increased to 42%. The increase was a result of our fixed cost of interest for our FIN 48 liability being applied to a lower pre-tax income amount and due to some discrete one-time tax items. We anticipate our book tax rate to return to 38.5% to 39.5% for the balance of fiscal 2008 as we continue to see the effects of implementation of FIN 48 which will drive more volatility in our booked tax rate than has historically been the case.

Moving on to the balance sheet, cash equivalents and short-term investments inclusive of restricted amounts totaled $359 million at March 31 compared to $401 million at September 30th, 2007. Debt totaled $1.7 billion at March 31 compared to $1.5 billion at the end of fiscal 2007. The increase in debt is directly related to the company’s stock repurchase efforts. In the quarter, we repurchased 2.3 million shares for an aggregate cost of $95.8 million, or at an average price of $40.87 per share. We have 27.4 million shares remaining under the stock repurchase authorization and we continue to expect this authorization to be exhausted by the end of March 2010.

Through the first six months of the year, IGT has deployed back to shareholders a total of $333 million through share buybacks and dividends. IGT will continue to be prudent in its capital deployment as we continue to find ways to grow our game operations business and acquire important technologies and intellectual properties.

Working capital totaled $718 million compared to $596 million at the end of fiscal 2007, with average days sales outstanding of 75 days and inventory turns of 3.2 times. Inventories have increased by $36 million since the end of 2007 as we begin ramping up for the delivery of new products over the rest of the fiscal year.

For the first half of the year, IGT generated $195 million in cash from operations, down from $367 million in last year’s first quarter. The decrease is primarily attributable to net income, timing of payments in working capital, and additional prepayments made to secure long-term licensing rights to recognize brands which help favorably differentiate our products in the marketplace.

Capital expenditures for the first six months of the year totaled $150 million compared to $182 million in the prior year. The decrease is mainly attributable to the prior-year purchase of a corporate aircraft. CapEx for the remainder of fiscal 2008 is expected to trend in a quarterly range of $60 million to $75 million.

That concludes my prepared remarks regarding IGT’s second quarter results. Thanks for your time and attention, and I will now turn the call over to TJ for his closing remarks.

Thomas Matthews

Thank you, Pat and good morning to everyone. Before we open the line for questions I have a few comments that regard our business and the outlook here at IGT. While this was a disappointing quarter financially, we still made progress in achieving our long-term objectives.

We had new products that began shipping in this third quarter, and our anticipated new cabinets have delayed some of our customer orders, with them expecting to take part in our latest offering. Of course we continue to concentrate on introducing new game themes particularly for the AVP, that’s a real core strength here at IGT.

We made several deals during the quarter which move us further along the path to successful deployment of server-based gaming. This morning we announced a deal for CityCenter. We also had previously announced the orders that we have for NexGen with Harrah’s, the strategic partnership established with WMS and that with PGIC as well. We also announced this morning through our Barcrest subsidiary a partnership with the Global Draw and Games Media in the UK, and then we have the pending potential transaction of CyberView. All of these should help us with our SB efforts as we continue to make progress on the timelines that we previously announced.

To remind people of those timelines, ‘07 was really the introduction of the concept to the marketplace: regulatory, agencies, and customers. ‘08 really has been the effort to prove the concept to ourselves technologically, to the marketplace in terms of impact on the customer.

We expect to have a field trial of SB 3.0 later this quarter and continue to feel comfortable that our timelines for having meaningful impact on ‘09 in terms of being able to prove the concept, and starting to get floor share for it will impact 2010 and beyond as previously articulated.

Our efforts continue to focus on driving the technological innovation forward and that we want to provide the best content and applications available for gaming floor and for casino operations.

On the capital deployment and strategy aspects of our business, we continue to invest in our business first with capital expenditures. That’s still really where we’d rather deploy our money is in continuing to expand our game operations and devising new technology. With that, we were going to consistently use our cash flow as opportunistic use of the balance sheet, as demonstrated previously with our stock repurchases and continuing to pursue that activity prospectively.

Our liquidity in the midst of this credit crunch remains solid. We have $1.7 billion available to us on our line of credit, and our current borrowing rate at LIBOR plus 3/8 is approximately 3%. All of these opportunities, as well as others being considered, will allow us to assist our customers who face tight credit conditions, will allow us to pursue partnerships that will acquire access to market and/or technology and at this time valuations of our peer companies for purposes of considering the partnerships and more are more attractive than they’ve been in recent periods.

Market expansion continues really in a very robust way even though there’s been a couple of setbacks. For instance, in the back half of ‘08, we’re going to have new shipments to the two racetracks in Indiana, and we have the systems deals for both of those racetracks. We expect here in Las Vegas the East Side Cannery to open up. There’s going to be expansions that are going to take place in Oklahoma and Connecticut. You’re going to continue to see expansions for instance, with Seminoles’ transition to Class III, the results of the compacts in California, and the ongoing build out of the market in Pennsylvania.

And the outlook that we have remains positive in that although there may be a project or two that is deferred, and there may be some projects that are delayed in terms of their opening there are a number of projects that are already out of the ground, and are going to likely to be completed despite the credit conditions and so we remain very optimistic that there’ll be over 100,000 new machines added within the next few years here in North America.

The international markets obviously are less affected by credit conditions to this point, but nonetheless we’ll be paying attention to them as well. The market development efforts that continue to exist for opening new markets we still are very optimistic. You have the Slot referendum in November for 15,000 machines. You’ve had successful votes this last quarter in Florida and in California, and though Massachusetts and Kentucky were unsuccessful we remain optimistic that those are going to probably approve gaming sometime in the next few years, and that the first serious attempts in these kinds of states generally fail. Pennsylvania for instance, took three tries. The election year is a very difficult timeframe for passing new legislation. It’d really be in a post-election cycle starting next year in which you might see progress made in those two jurisdictions.

Also internationally you’re hearing about the new government in Taiwan starting a debate for expanding gaming operations there. There’s proposals for large casino resorts in the Philippines; Macau continues to grow and in fact, that whole area of the world competing for emerging entertainment opportunities for the growing wealth that is taking place there.

In the way of guidance, we continue to expect an uptick in our business levels during the second half of the year as new and expansion opportunities open and we release our new cabinet and game titles. However given current operating conditions, we maintain our guidance at $0.35 to $0.40 for the next four quarters with the possibility of coming in at the high end, if not slightly exceeding this range in the second half of this year.

Similar to what we expect to see in fiscal 2008, new and expansion opportunities are again more weighted towards the second half of 2009 so we will revisit our guidance on future earnings calls as we gain further clarity to those opportunities.

Again we want to thank you for your time this morning and your interest in IGT and we will now open the lines for questions.

Question-and-Answer Session

Operator

The first question comes from David Katz - Oppenheimer.

David Katz - Oppenheimer

I have a couple. Just going back to a couple of Pat’s earlier comments -- and you do give out quite a bit of information; I apologize if I missed any -- but did you give out sort of an average selling price domestically and internationally? I know you gave average revenue per unit, right? But we’re trying to sort of break out that product sales business between the non-machine domestic and international.

If you could talk a bit about the margin on each of those three pieces, that’d be helpful also, irrespective of the non-machine sales.

Patrick Cavanaugh

David. I didn’t give ASP, I gave ARPU. David, I’m going to have to circle back to you on that. I don’t have it with me.

David Katz - Oppenheimer

Can I just move to the next issue? I heard all the comments about the back half of the year, and in terms of new product, new content and new cabinet impacting this current quarter that we’re in right now as well as the following one, are our expectations still the same as they were two, three months ago in that respect?

Thomas Matthews

They are. More than 50% of our shipments in this last quarter were AVP related, and we expect that that percentage is going to grow in the back half of the year. We have the normal issues with introducing new products to the marketplace. You freeze some purchase activity, I think that’s probably a little bit about what happened with the numbers in Q2 and you have, of course, the risk of getting timely approvals for the cabinets, the hardware, the underlying platforms, the games to be deployed on those. So there’s certainly some timing elements that we still need to get through in Q3 and Q4.

But we feel very good about the products that are to be introduced. All of those of course make floors SB-ready as they are deployed, and so far have been very favorably received as we present them to our customers. As a result, our backlog is up a great deal quarter over quarter.

David Katz - Oppenheimer

Lastly and then I’ll give someone else a chance. The memorandum of understanding you announced this morning, can you give us some sense of timing as to when that product has to be completed, approved and ready to deliver to CityCenter and how that timeline works out?

Thomas Matthews

Sure. If you remember, there are a number of system products that we already deploy into the market that there really is no development associated with. That includes Advantage. Advantage is patron management, includes bonusing, the back of the house accounting. That will remain as it currently is operated for CityCenter and for other new installations.

There’s also our Table ID piece, there’s the opportunity for us to obviously introduce ticketing, and at CityCenter we may have an opportunity to deploy Mariposa as well. We continue to explore that opportunity. So really what we’re doing is layering on top of that the SB functionality. The SB functionality timeline goes like this: 3.0 hopefully will be in the field with a field trial for purposes of getting Nevada approval sometime this quarter with the approval probably lagging upwards of 60 or 90 days if all goes well.

That is the core functionality of download and game configuration being implemented. Later in the year, you’ll see the SB Window implemented in two phases. First, just it being incorporated onto the boxes themselves and secondly being activated by player card insertion allowing for a more interactive experience.

It really isn’t until we get to SB 4.0 that you start realizing some of the application deployment that we’ve been talking about that really can make a difference in terms of point-of-sale marketing, providing functionality like tournaments on demand, being able to have a more robust bonusing effort, being able to target consumers as we recognize them and their play activity, being able to as a result maybe tailor the experience some. All of that comes with SB 4.0, and our goal is to have that available to CityCenter upon opening.

Right now we feel comfortable that we will accomplish that goal. The good news is that the functionality of the floor is not dependent on us realizing that goal, and so right now I would say that I think their opening is aimed for November of next year and for the time being, we can say that we’re comfortable that we’ll meet all of their required timelines.

David Katz - Oppenheimer

There was no sort of company announcement or anything like that, but we did pick up in some of the trade rags about some of the changes being made in your SB team. Is there anything that’s discussable about any of that or any color you can offer us on any of that?

Thomas Matthews

Well, for the most part the team remains as it’s been; SB applications and the definition of the product have been led by a fellow named Rich Schneider for all this time. Rich Schneider came to IGT with the acquisition of Acres Gaming back in 2003. He was President of Acres, managed integration of our systems businesses between the two respective companies, and for the last couple of years has had the responsibility of overseeing SB.

He really has played the pivotal role of going out and helping us secure customer agreements and some definition as to what the first phases of the product needed to be. Of course has been integral in the kinds of cooperation that we need from our peer companies as well and so he’s been helpful to that as well.

So from that perspective, there have been no changes. We did have a fellow by the name of Andy Ingram who was in charge of all networked gaming systems for us: that included not only the SB effort, but that included Mariposa, EZ Pay, Table ID, and he has left the organization.

He was important for us in terms of kind of communicating the open platform publicly. But realistically if you take a look at Rich Schneider, who has a very long history in the industry, that’s something that he’s been doing for 20 years. And in fact he’s a past President of GSA. GSA is the industry association that we support for advocating open protocols, and something that we anticipate really is required for the network floors of the future to be able to bring functionality across the floor.

So I think there’s a little bit been made of this one departure, but really no changes to the underlying core team, both defining that product and developing the product.

Operator

Our next question comes from Steve Kent - Goldman Sachs.

Steve Kent - Goldman Sachs

Could you talk a little bit about with some of the weakness in some of the sales, especially domestically, whether you think that that’s a function of competition or the slowing economy? Maybe you could address this issue about operators facing a tougher time over the next few quarters and their desire or ability to commit to CapEx on slot machines.

Thomas Matthews

So to answer the first question about replacement sales, we’ve remarked in the past about the fact that we perhaps over-penetrated the market in the wake of EZ Pay deployment, that we were early adopters of that technology and had an advantage with that first mover positioning. As a result of that, there’s been some recalibration of floors. I think it continues to show itself in shift share to replacement opportunities, in that that’s lower than what is our historical install base.

I think some of that is result of our own activity. I think the slowing down on replacements in some instances is an easy decision for deferral of CapEx by our customers, probably less that they’re affected by the economy but trying to understand whether or not they will be affected by the economy for an extended period of time as well as some of their own capital structure issues as a result of their access to capital given the change in the credit market.

I certainly would be remiss to say that there was no competitive impact; there is. Competitors are doing a better job right now, both having access to current technologies and doing a better job with their games. I would say that we would never use that as an excuse, though. I mean, it’s our job to go out and secure 60% plus of the floor.

If you take a look at new properties, which is really still to me the beacon of our strength, you see that we still accomplish those kinds of penetration rates when places open. So I feel very comfortable about what our competitive standing is, understand that on the margin in the replacement environment that we have slipped a bit but it is with these new products that we are introducing this quarter, the biggest effort ever in the history of this company for introducing new cabinets, new platforms, new games, all in advance of this very industry-changing technology that we call SB.

I feel very comfortable that we are going to start growing our share of replacement demand and in fact can start simulating some replacement demand. But the economic factors that cause the timing to be determined are in the hands of the operators, not ourselves.

Steve Kent - Goldman Sachs

T.J., just changing for a moment, on participation revenues where we’re seeing some regional markets show some weakness from your perspective, is demand still so high for your product that you’re not seeing the impact as much as maybe the broader market would suggest? Maybe in that light, if you are or not, have you been able to see any deceleration as we’ve gone through the quarter and as the economy seems to be softening in play on your participation games?

Thomas Matthews

I think that the primary impact on play levels this quarter is seasonality. That’s why they’re up sequentially. But that year-over-year comparison, I think really going into the quarter we would have expected a slightly bigger uptick due to seasonal factors and as we started measuring both directly, since we can with our wide area progressive systems and indirectly, just seeing some of the results of the market, there’s no doubt that play levels maybe weren’t as robust this year as were hoped for.

Our games work because they’re the most popular, and so we’ve always said that we think they’re the first games played and the last games to stop being played. And so, yes, I mean, we think that our products probably are slightly less impacted by the overall economic impact on play levels than are other of our nonparticipation games. But that said, if there’s less total spend going on in a casino environment, our games are going to be included in that.

Operator

Our next question comes from Joe Greff - Bear Stearns.

Joe Greff - Bear Stearns

What was your estimated domestic shift share in the March quarter, and how does that compare to the last few quarters?

Thomas Matthews

I think we were probably in that 40% range, and that’s been about where we’ve been now for the last four to six quarters.

Joe Greff - Bear Stearns

As you introduce new cabinets and new titles, I presume you’re going to see somewhat of a decline on the non-machine, non-box revenues? How much of a decline do you anticipate with new cabinets and titles being introduced?

Thomas Matthews

Obviously the goal of SB is for us to figure out incremental applications, change the way that we sell game content into the marketplace, and so there could be a little pickup in turns of kind of the run rates. But we really haven’t anticipated much.

If you take a look at non-box revenues, they’re split about one-third, one-third, one-third to intellectual-property systems and conversions, conversions and parts. And so it’s really only that last category that’s a bit at risk as people stop supporting the older platforms and move to these newer platforms. But our systems business we expect is going to continue to grow and we think there is some real opportunities for us to continue to grow our IP business.

I think in total we anticipate that that is still a growing line item.

Joe Greff - Bear Stearns

Then in that $0.35 to $0.40 quarterly EPS range for the next four quarters, I’m presuming you’re factoring in nothing more than $100 million a quarter of buybacks. Is that fair to say that?

Thomas Matthews

Well, I think that our buyback strategy has been articulated in that we’re going to try to exhaust the existing authorization by March 2010. To do so I think initially required around $175 million a quarter which was in excess of our stated goal run rate of $100 million. I think that stated goal rate of $100 million is still a good one to use for assumption purposes, but we remain opportunistic. So if you see share prices decline, as they have in anticipation of these results and the overall economic impact on the industry, I think that there’s an opportunity for us to assess whether or not we should exceed that level.

Joe Greff - Bear Stearns

You talked earlier about the timing with respect to the CityCenter MOU. When do you anticipate that to be a finalized, signed formal contract?

Thomas Matthews

The MOU is largely binding upon the parties. So for us we have the formal execution of sales documents that are going to follow this tentative agreement. But I would say that the MOU for most respects represents a final agreement between the parties.

Operator

Your next question comes from Steve Wieczynski - Stifel Nicolaus.

Steve Wieczynski - Stifel Nicolaus

Can you just quickly break out the interest expense versus income?

Patrick Cavanaugh

Interest income was $17 million. Interest expense was $25.1 million. Other was an expense of $800,000.

Steve Wieczynski - Stifel Nicolaus

Going back to the CityCenter deal I assume you’ve been in discussions with them about the economics of how the deal will work. Can you give us some more color in terms of that?

Thomas Matthews

Well the deal for SB, I think, as we remarked in the past, in some respects remains to be determined, but the underlying business relationship of providing Advantage and other systems products remains the same. The idea is that we sell boxes in this case the AVP platform, all in the new cabinets with those LCD top boxes, is a one-time sale of hardware. We’ll start having an opportunity to package game content both with the initial sale of boxes but subsequently delivered on a floor-wide basis across the floor. That’s probably going to be a one-time charge based on number of seats that the product is made available to.

We’re going to try to introduce new applications and those applications will have probably some upfront charges as well as some recurring revenue charges for supporting those applications, keeping them fresh, ongoing development in the matter. We’re going to have some IP charges, especially as it relates to certain of our technologies being made available to other vendors as they try to bring product to the casino floor. So all of those elements are at play here.

We have, as you would imagine, some incentives given to early adopters, and certainly the MGM organization as a whole and CityCenter here specifically have really been terrific in that they have oftentimes been early adopters of the technology that we’re trying to bring to the industry. We very much appreciate that partnership. But I don’t think that the deviation is so great that the elements that we’ve previously identified, those kind of six categories or so of areas that we might be deriving revenues as we deploy SB, I think are all intact here and all present opportunities as it relates to the CityCenter deal.

Steve Wieczynski - Stifel Nicolaus

Do you expect further announcements from other operators throughout the year?

Thomas Matthews

I sure hope so. I mean, that’s our job here is to go and try to figure out ways that we can expand our customer opportunities. We’re not much for making press releases, as you know, as it relates to securing new business because we think that is something that we do in the ordinary course. So every systems deal we get we don’t announce and every time we get a machine order we don’t make any particular celebratory noise about it; that’s what we do.

In the case of SB, I think that these early adopters of Harrah’s and MGM are very important to make known. I think there’s probably a couple more that we’re working on, especially within our existing customer base for Advantage that are obvious efforts for us to deploy SB. I think if we make meaningful progress there we’ll probably go ahead and make sure that we let the market know. But over time we expect to be selling an awful lot of SB systems and probably not announcing every one.

Steve Wieczynski - Stifel Nicolaus

Can we get an update on the CFO search? It’s kind of been dragging on now for a while.

Thomas Matthews

It has been and unfortunately I think that it’s mostly been a product of me in that I’ve been particularly picky on behalf of IGT. I think that we really want to make sure that when you get a person into that position that they can immediately help us with our global expansion, the transactional activity that we’ve got going on, on an ongoing basis, help us address capital deployment and including capital structure items; and, that they’re the right personality fit for this organization in a way in which they can represent us to a variety of external communities.

So being that particular has meant that we’ve gone down the path here and there with a couple of different folks but have yet to really figure out just that right fit. It’s an ongoing effort and unfortunately at this point I would say with no imminent announcements.

Operator

Our next question comes from Celeste Brown - Morgan Stanley.

Celeste Brown - Morgan Stanley

I couldn’t tell if you were saying you might see a breakout of the $0.35 to $0.40 range in the back half of this year, or were you saying the back half of next year?

Thomas Matthews

Well, what we said is that we think that there’s still, I believe mentioned on the last call, additional opportunity for us to exceed the range in one or both of the quarters in the back half of ’08 simply because we do have such good visibility to machine demand.

The thing that could get in the way of that is deferrals, that purchase activity, either due to our inability to get approvals or due to either projects being delayed and/or customers just deferring decisions to future periods. So there’s certainly some risk to that visibility.

There’s a natural uptick that we expect in game ops due to the seasonality. These next six months are the best six months of the year for game play levels. We think international kind of rebounds to more normalized levels and so there’s reasons for us to feel good about that range, including maybe being on the high end or exceeding the range for the next couple of quarters.

You see us go back into ‘09 in a way in which we’re back to this kind of first half of the year where there’s seasonal impacts. There’s still us being somewhat dependent on new properties which we don’t control, and replacement demand still weighing a little bit in anticipation of truly new technologies being deployed.

Going into that second half of ‘09, however, you can identify a lot of new and expansion opportunities for us to sell product. By then we expect that we really are starting to stimulate replacement sales here at IGT in advance of active SB decisions being made by our customers. So we don’t have any guidance yet for the back half of ‘09, but feel very good that there’s a real opportunity for that to be the strength of that fiscal year.

Celeste Brown - Morgan Stanley

T.J., it sounds like you’re accelerating your expected delivery of SB 4.0. I thought CityCenter would get 3.2. Is that going to be a challenge in terms of personnel?

Thomas Matthews

No, it’s not, not on the personnel side. I mean the challenge, of course, is that we are developing a very broad system from scratch, and so just maintaining proper product definition and meeting those internal timelines is really the challenge. Of course along the way we’ve changed specifications somewhat of the underlying technologies. We have redefined some of the applications that we have as priorities, and still are working with customers to make sure that we kind of meet their initial requirements for the product. So there’s some movement of parts as far as that is concerned but I think we feel comfortable that we have the resources necessary for timely delivery.

4.0 is due right around that CityCenter opening and so where we are hoping that it’s deployed, it is 3.2, as we previously said that we for sure will have deployed in that property. If everything goes well, we have perhaps 4.0 in advance of that opening or maybe shortly thereafter.

Celeste Brown - Morgan Stanley

Then you talked about maybe an interim step, is that 3.1? What led to the decision to have the interim step in terms of your versions?

Thomas Matthews

We had the opportunity for us to secure some gaming approvals and customer acceptance of really what people have originally defined server-based gaming as in the way of download gaming config. We wanted to go ahead and get that done, have the proof of the technology that we could have this broadband delivery of various applications.

As you know, in our minds what distinguishes this product from previous interaction with the player is that we’ve moved the customer interface to the primary game screen and so deploying the SB Window is also in our minds extraordinarily important to core functionality. That’s why it’s still in that generation 3 effort. 3.1 and 3.2 are just perfection of delivering that SB Window. So that’s the reason it’s being phased is just for us to secure timely gaming approvals.

Operator

Our next question comes from Bill Lerner - Deutsche Bank.

Bill Lerner - Deutsche Bank

When you look at SG&A this quarter, I think it was about 28% higher than last year. Of course revenue was down mid single-digit, I think 6%. How do you reconcile that? I would suspect it’s a function of what you’re seeing in demand in the pipeline.

Thomas Matthews

Sure. If you take a look at SG&A, with all the noise removed of both last quarter’s hurricane proceeds and the sale of aircraft and this quarter’s one-time item items associated with a few internal decisions relative to the economic environment in which we’re operating, the SG&A year over year is actually reasonably flat to comparable figures.

R&D is up, and depreciation is up because of the growth in the install base. And so there is some growth in operating expenses in total. But hopefully that reflects either previous growth or ambition for growing the company prospectively.

SG&A needs to be sized right. I mean, all operating expenses need to be sized right relative to the overall size of the business so that we have goals, as you know, of bringing at least 30% of our overall revenues to the operating income line. We’ve been historically able to do that by realizing margins let’s say in the neighborhood of 50% to 55%, and then the rest of that is captured within operating expenses. So we forecast operating expenses at 26% to 28% in the back half of the year. I think that that’s probably a good run rate for us going to ‘09. But if for any reason we ever felt like revenues weren’t going to trend up to properly support these expense levels, we would go back and revisit our spending and cut if necessary.

Bill Lerner - Deutsche Bank

Thanks, T.J. The follow-up is just a little bit of color, if you can provide on MGM or CityCenter. What sort couple applications have gotten them so jazzed up that they want to essentially allow you guys to announce this early? Also what is Harrah’s seeing about an interim solution with NexGen that they want to deploy the way that they are?

Thomas Matthews

I think that the biggest thing that people really believe in is that SB Window, the idea that we’re going to have a much better customer interface than we’ve ever had in times past. We’ve talked about this a little bit, and that if you take a look at the original player tracking systems, up until just seven years ago, those were two-line dot matrix displays for messages to the player. NexGen was revolutionary in that we had the ability to articulate a much more robust message, and as a result support bonusing. The bonusing that’s really made a difference of course is Lucky Coin, which is branded differently at a couple of different places but the idea that you have a floor-wide mystery jackpot, and Extra Credit, which is the idea that you automate some of the player tracking comp conversion to play activity at the machine. The idea that you can expand on that and have things like tournaments or a more robust Lucky Coin promotion.

It’s better articulated to the player, or the player can access their activity more readily through the SB Window as opposed to some form of lookup window that we can direct-market various customer messages to them to try to impact their overall behavior across the floor.

I mean a place like CityCenter, for instance, as you know really only anticipates maybe 40% or even less of their overall revenues being driven on the gaming floor. So they’re trying to anticipate ways that they can drive revenues while they have a captive audience by getting messages to the players at the gaming devices.

SB Window I think has really been the decisive rationale for Harrah’s and MGM to go ahead and make the SB commitment. But in the case of MGM and CityCenter, it’s also an expansion of what has been a long-standing system relationship and so for them, we’ve really appreciated the support that they’re big believers in Advantage and the things that we’ve already done with floor-wide efforts, and they just see us continuing to be able to offer more under this new delivery mechanism.

Bill Lerner - Deutsche Bank

I’m just noticing as you’re saying this, the stock’s down 11% on the back of lots of weakness in the last several weeks or what have you. Does that make any sense to you, based on what you know about the outlook? I mean I understand the quarter was weak, but I just wanted to get your view on that.

Thomas Matthews

I think that there was some headline risk to today’s press release in that people who aren’t necessarily trying to be long-term investors might make decisions based on the first couple of sentences in the press release. I think that folks that have made long-term commitments obviously are following the progress that we are making on delivering SB and being able to assimilate replacements, being able to follow the ongoing growth of our game ops installed base, and the reliability of that business. Although play level is somewhat affected by economic factors this last quarter the fact is still an upward trend is alive and well there. Non-box sales demonstrate diversity away from this core need to ship boxes.

I think all those things that have made us an interesting company for long-term investors very much remain intact. The fact that we can be on a call and remark on visibility to a much improved environment for the back half of ‘08 and reasons to share optimism about ‘09 and really know that SB will be delivered and impacting our 2010, none of those things have changed. So the day-to-day changes in the overall valuation of the company don’t always make sense in terms of really reflecting what is, I think to people that are close to our efforts, the underlying strategies.

Operator

Our next question comes from Robin Farley - UBS.

Robin Farley - UBS

Can you quantify how many of the game operations units that were removed sequentially, how many of those turned into product sales?

Patrick Cavanaugh

Most of them did, Robin. It largely had to do with when you saw Class III approved in Florida for the Seminoles, that led to a number of removals there of our previous Class II products. Then in California, the same thing with the compact amendments being approved, you saw a number of our Class II devices again removed in favor of product sales, but it was pretty much a one-to-one swap out.

Robin Farley - UBS

So in other words, it’s like all 800 casino removals if it was 800 removals and no additions?

Patrick Cavanaugh

Well, we had some other ongoing additions, but nothing of any significance.

Operator

And our final question comes from Amir Markowitz – JP Morgan.

Amir Markowitz – JP Morgan

A quick question about your game ops margins. You commented on I think it was 57% to 60% kind of outlook going forward. What kind of interest rates are you guys assuming? Say LIBOR continues to decline, do have that factored in?

Patrick Cavanaugh

We do. What we’re currently looking at is we use the Fed funds futures, Amir. What we’re seeing in that is another 50 basis points, I believe, in the June quarter and then nothing after that so far.

Amir Markowitz – JP Morgan

The other thing about server-based gaming in the MGM deal, when you talk to MGM, do they give you a sense of if things go well at CityCenter if they would roll it out, a similar solution to their other properties?

Thomas Matthews

I think that’s the goal that we have is that we can demonstrate into new properties on a discrete basis on a couple of trial floors in advance of that the opportunity for us to really grow revenues as well as maybe help capture some managed expenses.

So if we can do those things, then we think that we’ll have a compelling ROI presentation for us to be able to present to our customers a rationale for them replacing or upgrading existing floors. If you take a look at the trial location that we have for 3.0, it is another of the MGM properties and so that does demonstrate that corporate-wide they’ve been big supporters of these efforts.

Well, given that was the last question of the call, I very much appreciate everybody’s attention this morning and look forward to remarking on what will be a much better quarter on our next conference call. Thank you.

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Source: International Game Technology F2Q08 (Qtr End 3/31/08) Earnings Call Transcript
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