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International Game Technology (NYSE:IGT)

F3Q08 Earnings Call

July 17, 2008 9:00 am ET

Executives

Patrick Cavanaugh - Vice President, Corporate Finance & Investor Relations

Thomas J. Matthews - Chairman of the Board, President & Chief Executive Officer

Daniel R. Siciliano - Chief Accounting Officer & Treasurer

Analysts

Robin Farley – UBS

David Katz – Oppenheimer & Co.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Joseph Greff – J.P. Morgan

Steven Kent – Goldman Sachs

William Lerner – Deutsche Bank Securities

Rachael Rothman – Merrill Lynch

Operator

Good morning and welcome to the IGT third quarter fiscal year 2008 conference call. At this time all participants are on listen only. After the presentation we will conduct a question-and-answer session. (Operator Instructions) I’d like to inform participants that today’s call is being recorded. If you have any objections you may disconnect at this time and I’d also like to turn the call over to your conference host this morning to Mr. Pat Cavanaugh, Vice President of Corporate Finance and Investor Relations.

Patrick Cavanaugh

Good morning everyone and welcome. 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 call certain statements and responses to questions may contain forward-looking information including forecasts of future financial performance and estimates of amounts not yet determined, the potential for growth of existing and the opening of new markets and products, play levels for our install base of recurring revenue games as well as our future prospects and proposed new products, services, developments or business strategies. Actual results could differ materially from those projected or reflected in our forward-looking statements and reported results should not be considered an indication of future performance. IGT’s future financial condition and results of operation as well as any forward-looking statements are subject to change and to inherent known and unknown risks and uncertainties. IGT does not intend and undertakes no obligation to update our forward-looking statements including any comments regarding our earnings expectations to reflect future events or circumstances.

All forward-looking statements made in this conference reflect IGT’s current analysis of existing trends and information and represent IGT’s judgment only as of today. You should not assume later in the quarter or year that the comments we made today are still valid. Actual results may differ materially from current expectations based on a number of factors affecting IGT’s businesses including unfavorable changes to regulations or problems with the obtaining or maintaining these licenses or approvals, a decrease in popularity of our recurring revenue games or unfavorable changes in player or operator preferences, for general decline in play levels, decreases in interest rates which in turn increase our costs or jackpots, slow growth in the number of new casinos or the rate of replacement of existing gaming machines, failure to successfully develop and manage frequent introductions in innovative products.

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

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

With that being said, I’ll move on to a discussion of the quarter’s results. Earlier this morning we reported for the third quarter of fiscal 2008 net income in the third income totaled $180 million or $0.35 per diluted share compared to $136 million or $0.41 per diluted share in the prior year quarter. Given the current operating environment we are pleased with our Q3 results which are the second best in the company's history in terms of revenues and gross profits. These results were primarily driven by strong domestic new unit demand and a record contribution from our Latin American subsidiary and strong non-machine sales during the quarter.

Going over some of the more specific details, first starting with gaming operations, our gaming operations business generated revenues of $334 million in the quarter which was down 2% both sequentially and year-over-year. Gross margins were 61% for the quarter versus 62% in the prior year. Our install base ended the third quarter at 59,200 units up 1,000 units year-over-year and 500 units sequentially. We earned an average of $62 in revenue per unit per day versus 66 in the prior year quarter and 64 sequentially. The decrease in revenue per unit both year-over-year and sequentially is due to lower play levels resulting from the current operating environment and the growing mix of lower yield in stand-alone and lease operations units.

Historically our third quarter has realized an average yield growth of 3% to 4% compared to our second quarter due to more favorable seasonal play levels. Similar to what we saw in the second quarter we believe yield under performance can be attributed to the unfavorable economic environment as well as ships in our install base mix. Major markets across the country reported significant year-over-year declines in gaming revenue and those affects flowed through to the revenues from our gaming operations machines. The mix of games within our install base is shifted toward more stand-alone and leased base models which generally carry fixed or lower daily fees.

In the casino operations sector of our install base we ended the quarter at 39,700 units up 100 units from last year but consistent with the sequential quarter. In the lease operations sector our install base totaled 19,500 units at quarter end up 900 units year-over-year and 500 units sequentially. The growth was mostly attributable to installations in our install base in the UK. Taking into account lower interest rates and current market expectations for rates game ops gross margins are projected to trend between 58% and 61% with fluctuations based on the timing of jackpots, interest rates and the mix of games in our install base. Given the current environment we expect growth in our install base over the next quarters will mostly come from our international lease operations sector mainly the UK and Mexico.

Moving into product sales, product sales revenue totaled $344 million for the quarter compared to $365 million in the prior year. Worldwide we shipped 20,200 machines during the quarter down from prior year shipments of 36,900. Domestically we saw continued low levels of replacement demand but a pick up in new capacity. Part of this quarter’s lower level of replacement demand was in an internal decision based on manufacturing capacity and a prioritization of new or expansions put in the queue ahead of replacement so we hope that in Q4 we could see an up tick in replacement demand. Internationally fewer shipments in Japan and the UK were partially offset by stronger shipments into Latin America.

Non-machine revenues comprised gaming systems, gaming conversions tables, parts and intellectual property fees come in at $115 million for the quarter or 34% of total product sales for the quarter compared to $92 million and 25% of total product sales in the prior year quarter. This was the second best quarter ever for non-machine sales revenue which was driven by the growth in our Advantage Gaming System sales and intellectual property fees. Average revenue per unit for the quarter was $17,000 compared to $9,900 in the prior year quarter. The 72% increase was driven by the increased share of revenues from non-machine sources, stronger realized sales prices related to the mix of APB sales plus a lighter mix of sales into our lower priced Japan and UK markets.

Product sales gross margins were 54% up 300 basis points from the prior quarter driven by fewer machines shipped into lower priced markets of Japan and the UK and strength in non-machine revenues which have historically generated margins North of 70% in most periods. Going forward we expect product sales margins to slightly decrease to the range of 50% to 53%, margins will fluctuate as IGT realizes additional box demand relative to non-box revenues and depending on the mix of games sold in Japan and the UK.

Going into more detail on the breakdown of product sales, domestic versus international, first domestically, product sales revenues totaled $233 million on volume of 12,200 units for current quarter compared to $213 million and 12,800 units in prior year quarter. Domestic replacement shipments totaled 3,600 units for the quarter down from 6,400 units in last year’s quarter. Due to numerous casino openings and expansion new unit shipments were 8,600 units for the quarter up 2,200 from last year’s quarter and 6,300 from the preceding quarter. Domestic non-machine revenues totaled $87 million in the quarter an increase of 28% from the prior year’s quarter. Higher sales were driven by a number of new installations of IGT’s Advantage Systems and an increase in our intellectual property fees. Domestic average revenue per unit was $19,100 compared to $16,600 in the prior year quarter. Sales of machines utilized in our AVP platform reached 66% of total North American machines shipped during the third quarter. AVP machines are premium priced products that generally sells for $2,000 to $3,000 more than our Legacy platforms due to the increased cost associated with the additional technology included in the unit. We anticipate the mix of AVP machines will comprise even a greater share of our machine sales in future quarters as our Legacy platforms are slowly phased out.

International product sales revenue totaled $111 million on volume of 8,000 units compared to $152 million and 24,100 units in prior year quarter. We did not release a new game in Japan during the quarter while last year’s third quarter saw 14,900 units sold into the Japanese market. Latin American shipments increased nicely over the prior year quarter due to demand from Argentina but saw modest reductions in Japan and all other international casino markets in the UK. International non-machine sales were $28 million up 20% over the prior year quarter. The increase was driven mostly by increased parts [inaudible] in demand. International average revenue per unit totaled $13,900 up 121% over $6,300 realized in the prior year quarter. Average revenue per unit increase was mainly driven by fewer low price machine ship into Japan and the UK as well as our higher non-machine sales.

Product sales will continue to fluctuate quarterly depending on the geographic mix of sales and the mix of non-machine revenues. We anticipate new and expansion unit sales to moderate in the next three quarters based on what we see in new property openings during this period. With our previously announced six new products utilizing the AVP platform now approved and being shipped we expect a moderate pick up in replacement demand in the fourth quarter of 2008 and into 2009.

Moving on to operating expenses, total operating expenses were $201 million compared to $180 million in the prior year quarter. SG&A inclusive of bad debt totaled $123 million an increase of $17 million over Q3 last year. We realized higher staffing related costs associated with sales and administration headcount, bad debt provision totaled a net expense this year of $4 million compared to a net credit last year of $2 million in prior year quarter. R&D expense totaled $58 million for the quarter up from $51 million in the prior year as we continue to invest more heavily in product innovations and our server based gaming initiatives.

Depreciation and amortization within operating expenses totaled $19 million for the quarter down from $22 million in the prior year quarter. Total depreciation and amortization inclusive of depreciation on game ops machine is recognized in our cost of goods sold for game operations was $64 million for the quarter down from $66 million in the prior year quarter. All in lower amortization expense was partially offset by higher depreciation as a result of our 1,000 unit increase in game ops install base and the completion of our Las Vegas campus. Operating expenses in total were 30% of revenue due to the current quarter compared to 26% of revenue in the prior year quarter. Our target range for operating expense has been 25% to 28% of revenues depending on quarterly fluctuation and demand with the goal to maintain if not exceed 30% operating income margins. Accordingly we have undertaken an organizational review of our cost structure to ensure that we can achieve this goal.

Other income and expense net in the third quarter increased $5 million over the prior year primarily due to higher interest expense related to the additional borrowings on our line of credit. During the quarter our tax rate came in at 40%. The rate remains at elevated levels as a result of implementing FIN 48 and some discreet one-time tax items totaling $3 million excluding interest and penalties. We anticipate our book tax rate to remain between 39% and 40% as we continue to see the affects of the implementation of FIN 48 which will drive more volatility in our book tax rate than has historically been seen.

Moving on to a discussion of the balance sheet and cash flows, cash equivalents and short term investments inclusive of restricted amounts totaled $382 million at June 30th compared to $401 million at September 30th, 2007. Debt stood at $2 billion at June 30th compared to $1.5 billion at the end of fiscal 2007. The undrawn capacity on our $2.5 billion line of credit totaled $1.4 billion at June 30th. The increase in debt is directly related to the company’s stock repurchase authorization. In the quarter we repurchased 8.1 million shares for an aggregate cost of $266 million or $32.96 per share. Additionally from June 30th through yesterday we repurchased 6.5 million shares at an aggregate cost of $158 million or $24.18 per share. Our outstanding share count stood at 306.4 million at June 30th and was 299.9 million as of yesterday. We have 12.9 million shares remaining under our stock repurchase authorization as of July 16th.

For the nine month period ended June 30th, 2008 IGT deployed back to shareholders a total of $606 million through share buy backs and dividends. IGT will remain prudent in its capital deployment as we continue to find ways to support our business and acquire important technologies and intellectual property that will enhance our portfolio of product offerings. Working capital totaled $779 million compared to $596 million at the end of fiscal 2007. Average day sales outstanding of 85 days and inventory turns at 2.9 times. Inventories have increased $49 million since the end of 2007 as we begin ramping up for the delivery of new products in Q4 and into fiscal 2009.

In the first three quarters of the year IGT generated $361 million in cash from operations down from $565 million in last year’s comparable period. The decrease is primarily attributable to lower net income, changes in working capital and additional prepayments made to secure long term licensing rights to recognize brands which help favorably differentiate our products in the marketplace. Capital expenditures for the first nine month of the year totaled $222 million compared to $260 million in the prior year. The decrease is mainly attributable to the prior year purchase of a corporate aircraft and the Las Vegas campus cost. Cap ex is expected to continue to trend in the quarterly range of $60 to $75 million.

That concludes my prepared remarks regarding the quarter. I will now turn the call over to T.J. for his closing remarks.

Thomas J. Matthews

Good morning to everyone on the call. Before we open the line to questions I have a few comments that regard our business and our outlook here at IGT. As Pat mentioned the third quarter was the second best quarter in IGT’s history for revenues and gross profit with last year’s third quarter being the record for both. We accomplished this despite significantly lower volumes of machines shipped worldwide due to some weak replacement demand both in the United States and in Japan. Continued revenue weakness has also been seen in key US gaming jurisdictions and it obviously weighs on our results in game operations. As we continue to focus on generating increased financial efficiency we consolidate margins of 57% despite the lingering impact of much lower interest rates. We had non-machine sales that continue to provide a growing stream of high margin revenues that included six new installations of IGT’s Advantage Systems during the quarter including both at the new racetracks and Indiana and we continue to opportunistically reduce our share count. We’re now down to less than 300 million shares outstanding today which is an over 10% reduction to the share count in Q3 of 07.

The marketplace however has conditions that reflect competitive pressures and the operators are rationalizing their spending. Most are still buying but pricing effects are going to be felt in our recurring revenue products with some additional pricing pressure in the for sale market as our customers have an unprecedented amount of gaming machine choices to invest their own increasingly competitive market.

That said we had a good quarter in terms of our market share on orders over 100 units both new and replacement with approximately 54%. Though disappointing that this doesn’t compare to the 56% of floor share that we have as a result in the latest census I think it does go to serve the point that we’ve made oftentimes before that our new and expansion unit share is largely in tact and our issue is replacement. At this 510,000 previously sold IGT slot machines in the marketplace and they work and so it’s up to us to figure out new features and new functionality for us to be able to offer a reason to the casino operator to replace that product. There is no effort more important in doing that than our server based gaming efforts. This week the Barona Casino in California went live with our new version of 3.0 and this is the first version of our live field trial to fully utilize the GSA standards.

We still believe that the industry is going to grow and that that growth is healthy despite this gaming revenue slowdown. There may be some projects that are postponed or altogether cancelled but still our view to being able to see new and expansion units this past quarter and certainly again in the back half of 2009 is very good. We had numerous casino openings this quarter that’ll continue, we had new capacity growth in key markets such as California, Nevada, Florida, Pennsylvania, we have potential new markets such as Maryland and Massachusetts, there is really no change to our expectations that we will get to a million gaming devices in North America by 2010. International growth prospects especially in Asia look stronger than ever.

The issue for the quarter that weighed a little bit down on the results was that despite having a good quarter from a revenue and a margin standpoint we acknowledge that operating expenses are not at optimal levels. We are reviewing expenses company wide, as Pat had reflected. The goal here is to have 30% operating income margins. If we aren’t going to have the revenue growth breakout that we were hoping for this year and next and still waiting until 2010 for material SB impact then we need to manage expenses in a much more prudent, careful way so that we can keep it at fairly percentage of revenue range and we’ll make sure that we continue to undertake measures necessary to do that.

Our goal is to only to align ourselves financially with our business levels but to ensure that we continue to deliver innovative, industry leading products in a manner that maximize their financial returns to the shareholders. It does mean that there’s going to be certain projects that are near and dear and kept at probably high levels of funding especially within that R&D segment.

That brings us to the topic of guidance and the fact is that these conditions that we’ve seen in the marketplace are looking like they’re going to continue for the foreseeable future, they’re unprecedented. We’ve never really seen gaming play levels fall across all markets as we have in the first half of this year. If that continues that’s going to probably weigh a little bit on our game ops business and it’s probably also going to affect some amount of casino spend activity whether it relates to cap ex or op ex. So we at least need to be making sure that we’re paying attention to whether or not there is any change behavior in that regard. While we were able to return to our prior trend levels after that difficult second quarter that we reported we really don’t expect that we’re going to meaningfully build upon these results until the market conditions improve.

The result, I think our guidance for the next three quarters needs to be a range of $0.30 to $0.35. This range is not going to contemplate any efficiency measures we are able to implement over the period and it is likely that we’re going to be able to revisit our guidance on future earnings calls if visibility to future marketplace conditions improves and as I said in the back half of 2009 we know there’s new and expansion unit demand should make those results the kind of results that we can have maybe a slight improvement in the guidance that we’re giving here.

I want to thank you for your interest in IGT and I want to open the line for questions.

Question-And-Answer Session

Operator

(Operator Instructions) Our first question does come from Robin Farley – UBS.

Robin Farley – UBS

There’s a little bit more share repurchase in the quarter and obviously I guess that was opportunistic with the stock price where it is, I wonder if you could talk a little bit about your share repurchase intentions going forward and how much of that may be factored into your $0.30 to $0.35 guidance? My second question then is also just an update on the CFO search.

Thomas J. Matthews

On the share repurchase we’ve said that our goals are bifurcated into two buckets. That the one goal is we continue to generate excess cash and cash flow from operations greater than is needed for our reinvestment in the business so we have said that we would redistribute all that money back to shareholders if we weren’t able to find good investment alternatives for our owners and continue to do that and continue to do that at a pace that we’ve said is probably in the neighborhood of about $100 million or so a quarter as well as the ongoing dividend. Beyond that that we do not have an optimal capital structure. The capital structure is probably optimized, it’s weighted average cost of capital is probably optimized around 2.5 times leverage or so which allows us to opportunistically deploy even more cash back to shareholders if we see an opportunity to do so. Certainly this pricing environment for gaming stocks in general and IGT in particular does appear to afford us that opportunity and so we’ve previously said that the authorization that we had would be exhausted by March of 2010. That’s still our stated view but that if we retire that early because of the opportunity to do so that we would feel comfortable enacting on that. We made a lot of progress in that regard over the course of the last couple of months or so.

As it relates to the CFO search I have to say that we’ve done a much better job of getting the kinds of candidates through the door that represent people that can help our business as opposed to learn from our business and really have had a number of interviews with senior level executives that have very stable backgrounds that have been involved in a number of different kinds of transactions. We feel better about the candidate pull than we’ve had in the past but still no news necessarily on a hire date for a new CFO.

Robin Farley – UBS

Just to clarify when you talked about the $100 million per quarter, that’s really what’s factored into your $0.30 to $0.35 per earnings guidance, is that level. Is that right?

Thomas J. Matthews

The nice thing about share repurchase right now is it is very accretive at these levels and actually every $100 million worth of spend does produce some immediate positive impact on EPS. There could be some improvement in that range. Our goal is to make as much as we can both on a per share basis and a net income basis. If we see an opportunity for us to do it either through the way that we deploy capital or see some specific market opportunities we’re going to act on those. But $0.30 to $0.35 I think gives people a pretty good range of where the business, and not where IGT’s business is necessarily, but where the industry really is right now relative to what I think is a consumer recession that’s going on.

Robin Farley – UBS

A last question, you made a comment about market share but you can give specific where you’re seeing replacement market share?

Thomas J. Matthews

Our replacement market share is definitely lower. You saw ship share at very disappointing levels last quarter. It will be obviously better this quarter given the number of units that we shipped into new and expansion environments. Our issue is those 510,000 previously sold machines that we have not had a very good replacement strategy for them and we’ve been able to grow that install base with new and expansion as I’ve said, but haven’t really, with the exception of maybe five real slot machines, obviously some inroads from AVP haven’t had an across the board strategy for replacing those previously sold boxes. That changed this quarter. This quarter you saw six brand new boxes introduced to the casino environment, comprised the majority of our sales for this quarter, it is going to continue to do so. In prospective quarters we have another big product introduction with the MLDs that are coming out I think hopefully this quarter, at least into the mega-jackpot product line. You’ve got a real opportunity I think to move people from the existing hardware platforms to new hardware platforms. That probably cannibalizes some of the success that we’ve had with conversions but that’s okay, the hardware shipments will carry higher margins than conversion sales do.

The next step for us is to make meaningful progress on SB and to get people to start buying in front of SB in a way that they demonstrate that they believe in it. You saw I think really good progress in that regard with Harrah’s. I think you saw a good customer of ours like Stations prepare the Redrock floor and hopefully will prepare the Aviante floor for SB future, that you have now a commitment from City Center, you have the trial that’s going to go on at Barona now but also at Treasure Island for the Nevada field trial here in the next week or two. I think you’ve got some good progress being made there, where we’re really going to be able to start demonstrating functionality that has a meaningful impact on revenue.

If we can do that, then that may stimulate some replacement activity into 2009. Obviously there’s a lot of eyes focused on how November, 2009 at City Center goes and I think that’s when you’ll start seeing competitive reaction to making larger SB commitment given the fact that we succeed as we anticipate there. I think that there’s a better replacement story for 2009 except that I can’t predict what our customers are going to do relative to their own business issues as they confront lower play levels. Does that change cap ex? Does that change operating expenses? We haven’t really seen any of that but I think it would be foolish for us not to anticipate that they’re having those kinds of conversations.

Operator

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

David Katz – Oppenheimer & Co.

In terms of your replacement strategy I think one of the things we’ve been focused on is the roll out of some new product and if we can just be a bit clearer about how you expect the replacements to run. Does this new product change some of the dynamics in the replacement activities of your customers at this point?

Thomas J. Matthews

Again without regard to any changes in their capital expenditure activity, the answer would be yes. We have products that I think legitimately replace some of the previously sold equipment and it gives them an opportunity to do more business than they’ve had over, say, last year. Here’s the issue with share, here’s how you get to share for us. If you take 100 machine casino environment then 20 of those machines are really multi-game focused and that really has a heavy emphasis on poker and of those 20 machines 19 of those machines on average or more go to IGT. If you have take another 40% of the floor and you say that’s reel spot especially with this new trend to lower denominated multi-reel slot machines that our share in that segment remains at 60% or better, so that’s another 24 machines at 60% of 40. The struggle that we’ve had is in video, video reels and it’s just that’s a very competitive segment. I think that some of our competitors have done a nice job in that segment but there’s just a lot of competition there. So the 40 machines that remain in video reel our share is somewhere between 25% and 30% meaning that reel yield income of between 10 and 12 machines out of that category which gets you to our blended rate of about 53% to 55% share which is right in the middle of what we shift right in the middle of that.

That’s how a new casino is constructed. The problem with that 25% to 30% share in video reels, the real problem about it weighs on ship share is that our floor share for 8960 is about 40%. In other words, there’s a lot more IGT boxes out there on existing floors in video reel than a new casino would install. That’s where you’re seeing rotation away from IGT product into our competitors’ video offering. I really think with AVP we have a chance to both grow our market share again and get back to a 40% plus run rate for video share. Certainly it’s our intention to be 50% or greater in that category with time but it being so competitive and the barrier’s entry being lower whether or not that’s realizable remains to be seen.

I think that we have a chance to go and take back share but we also will see this whole ship share issue abate because there won’t be the pressure on existing floors to downsize our video reels by basically maintaining the existing population through conversion. They really will have an obligation to revisit repopulating their floor with new hardware platforms from IGT because effective October 1st we will only be supporting AVP with game development. We’ll still continue this for 8960 technically for a period of time and there will be some discreet developments for 8960s but effective October 1st our product is AVP for video reel and if you take a look at the products that were introduced, wide screen versions and normal versions both for the upright and the slant top we have a bar top product, in a bar top segment for instance, that’s 100% IGT business. So there’s some real opportunities I think for us to go capture replacement activity that we have not been able to pursue let’s say in the last 24 months or so.

David Katz – Oppenheimer & Co.

Two more quick ones if I may, the non-machine figures that includes some royalty fees and it includes basically some system sales and I assume some other. To the degree that you can give us some color about how much of that, because it is kind of a growing piece now, of really what’s in there and how much of it is royalties percentage wise, order of magnitude, that would really help.

Thomas J. Matthews

The IP royalties for the quarter were a little bit higher than normal but on an annual basis they’re about $40 million or so and obviously we’re growing that segment. We continue to have very large investments in intellectual property, more intellectual property owned or have access to than anyone else and do anticipate that as technologies change in the casino environment there’s going to be more opportunities for us to be able to realize IP revenues both from our competitors who want to adopt certain technologies but also as we move from hardware orientation to a software orientation with our casino customers. Hopefully that’s a growing dollar amount.

The rest of the sales in that segment I would say were about 50/50 between systems and parts of conversions. That’s probably a pretty good mix. We actually had a great quarter in systems revenue and that business is actually doing much better than people have acknowledged. For instance one of the things that you saw in last Q was we had increased in our install base of systems deployed by well over 100 systems year-over-year through the March quarter. I think we’ll be able to say the same again in the June quarter and it really is testimony to the fact that Table Touch, Easy Pay and Advantage still are the industry leaders in each of their respective segment.

The problem with the SB story and I think probably some of the frustration with investors that we’ve just been talking about to them. We’ve been talking about since now April of 2005 and it’s still November of 2009 before you see this big meaningful first deployment even though I think you start seeing a fair amount of commitments now with more successful field trials over the next six to eight months but it really belies the fact that the rest of our systems business is really in good shape, is generating really good revenues, that we really are the market leader in development there, that I think we’re stabilizing our customer base, we’ve let some of our competitors catch up a little bit with functionality that we of course believe infringes our patent portfolio but even so just with elapsed time have allowed them to catch up a little bit.

I think we quickly separate ourselves from the field again with the development that we anticipate over the next 12 months.

David Katz – Oppenheimer & Co.

One last quick one, Pat made a comment during his remarks about queuing up some of the product sales and putting some replacements ahead of new or new ahead of replacements, I guess my reaction to that was I would have thought that at these kinds of shipping levels there would have been more than enough capacity to eat whatever you kill, so to speak. Why would that be?

Patrick Cavanaugh

The reason being, David, is these are all new products and you have to retool the line and retrain your staff on how to build the product and obviously there’s no tolerance for slippage on a new opening versus replacement the band customers are generally much more flexible in terms of when they take delivery of the product. It really as simple as that.

Thomas J. Matthews

I think you’ll see that sort itself out in Q4, we’ll have a good replacement quarter here in Q4 and you’re going to see the manufacturing output has had a growth substantially through the course of the year and that’ll continue into Q4. To the extent there’s ever any short term capacity constraint it is always just that, short term and it really was kind of lateness in the quarter for AVP approvals that weighed on mix this quarter.

Operator

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

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Pat, real quick housekeeping, can you just break out the other income line?

Patrick Cavanaugh

Sure. Okay, Steven other income. Interest income $16.7 million, interest expense $23.2 million and other $1.2 million positive.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

T.J., just help me, going back to the guidance, walk me through this again. Last quarter you basically said that you maintained guidance at $0.35 to $0.40 a quarter and at that time you were basically saying it could potentially break out of that towards the end of the year. Now you go ahead and move it to $0.30 to $0.35. What has changed over the last three months? Have the markets deteriorated that much or are you just being conservative as a possible?

Thomas J. Matthews

I think maybe a little bit of both. Hopefully it is conservative and that we’ll see improved play levels. But what had happened in the first calendar quarter of the year, March quarter was somewhat unprecedented in that you had gaming play levels down and you had gaming play levels down for a whole host of different reasons in different markets. Some of it was competitive pressure, some of it was smoking bans, some of it was the economy. You didn’t have a whole lot of public acknowledgement of it yet because you didn’t have necessarily very good visibility as to how, if and at what degree it would continue. I think there was some hope that it was short term in nature. It turns out that April was worse and May and June haven’t necessarily reversed that trend. So I do think that we have to anticipate for our business that the economic conditions are likely going to continue like this for the remainder of the calendar year and maybe even going into next year in the early portion of the year.

That’s going to change because eventually year-over-year comps are going to look okay again. The smoking ban will start comparing against themselves, the competitive issues will sort themselves out. There really is a lot new and expansion activity that’s happening. Markets like Kansas supporting the new gaming law passed there, the compacting that happened in California. There really is good things that are happening in our market so we have a pretty good sense that this new and expansion unit demand that we’ve seen aggregating around the back half of 2009 and into 2010 is real and that is going to continue to be in place. The story for us is what happens to game ops revenues between now and then and what happens to our ability to stimulate replacement between now and then? Although I think we’re confident that hopefully we’ll be able to be at the high end of this range or even outside of the range on the upside, not knowing what this changed climate does to the behaviors of our casino operator customers causes us to have to be conservative about forecasting the business so that we can right size expenses appropriately against that kind of conservative outlook.

Steve Wieczynski – Stifel Nicolaus & Company, Inc.

Just real quick can you give me a quick shipment second run down on the Japanese market right now, what you’re seeing there?

Thomas J. Matthews

We will have a product introduced in this quarter and feel reasonably comfortable that we’ll have modest sales success with that product in Q4. Still looking like maybe we can have a game a quarter shift into an environment with much lower demand. I think the demand that we anticipate for the overall market in 2009 is something like 600,000 units of which our goal is still to capture upwards of 10% of that but really have been running at closer to the 6% level in terms of capture. This year just because of all the Reg 5 issues and some of our own issues with the timing of game development haven’t had very many shipments into the market at all. We’ll do a little better job in 2009.

Operator

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

Joseph Greff – J.P. Morgan

T.J., I was hoping you can expand on some of your prepared comments earlier, you talked about some pressures in the for sale markets. I think you referenced pricing there, are you talking about discounting from your competitors or are you talking about price increase pushback? I was hoping you can expand on that.

Thomas J. Matthews

I would say that we have not seen necessarily any direct evidence of pushback on pricing and we have I think a more rational competitive environment for the behaviors of our main competitors. But that said, the topic definitely comes up relative to some of our customers wanting to conserve either capital or maybe change the mix of weigh operating expenses, in some cases increase them, in place of capital expenditures, in other places decrease them. I would say that pricing as a conversation is happening maybe more now than it’s happened in times past but as you see our average revenue per unit, our average selling price are actually continuing to trend up and that really reflects our focus on developing better technology products within our product line for our customers. I can’t say that there’s any pressures there yet but I’m just mindful that they could show up with very short notice.

Joseph Greff – J.P. Morgan

With respect to the next three quarter of $0.30 to $0.35 of earnings what have you contemplated in terms of domestic replacement units per quarter? Do you think it’ll go below the 3,600 you did this quarter or is that somewhat sustainable given some of the new box introductions?

Patrick Cavanaugh

You’re probably realistically looking at a range I would assume somewhere between 4,500 and 6,000 a quarter. What we hope to stimulate more demand with the new units, the APV and the new cabinets. In an environment like we’re in I think it’s been realistic to assume we can get much beyond that.

Joseph Greff – J.P. Morgan

My final question, T.J. with regard to SG&A how much of that is fixed and how much of that is variable and how quickly could you take expenses out of there in an environment that’s likely going to be tough over the next year or so?

Thomas J. Matthews

My preference would be that we get to the 30% operating income margins through revenue growth not through revisiting our expense structure but given that revenues are basically flat year-over-year and expenses are up that has to cause concern and even over an extended period of time, when you compare like 2004 to 2008, it’s even more dramatic in terms of how revenue growth compares against the increase in operating expenses. We do have to take a look at it. I think that there’s enough there that we can probably act on it reasonably quickly. There is a large variable component. The problem is is that you don’t want to, as you know, starve the R&D budget all. That’s really what’s going to drive for us the opportunity to replace these 510,000 boxes with new hardware alternatives and we want to make sure that we preserve the key efforts that we have with respect to that while at the same time understanding that anything below 30% operating income is deemed unacceptable by us and presumably by the co-owners of the business.

Operator

Our next question comes from Steven Kent – Goldman Sachs.

Steven Kent – Goldman Sachs

Two questions, first T.J. just strategically given the amount of competition on that video front, do you think that you’ve just focused your organization maybe too much on server based and not on just simply finding hot titles and exciting new games. Is there a readjustment going on strategically within the R&D and just within those departments? Secondarily, on the participation placements I guess I’m always surprised by this, in a slowing economic environment, slowing play environment, why aren’t we seeing the operators put on more machines since they’re virtually free to them or is it an issue for you now because of the working capital required to put those machines out there? It does cost you a little bit of money to put those machines out.

Thomas J. Matthews

I’ll answer the second question first. No working capital constraints for us. We still generate as I said before more cash than we need to reinvest in our business so we have the opportunity to build a whole lot more units and deploy them on a participation model to our existing casino customers and would love to do so.

On the customer reactions I think there’s two camps. There’s a camp of people who in fact as you said are trying to move capital expenditures into operating expenditures. There’s been some public comments by a couple of operators on that subject and I would expect that you may see some increased installations from them while at the same time there’s a lot of folks out there that are trying to conserve capital either because of the way that the capital structure of their company is currently in place or they’re trying to improve their EBITDA margins with some short term cuts to operating expenses and that puts some pressure on the number of units installed.

There’s also probably a slight rotation of machines from the jackpot portion of our business into more of a stand alone orientation which is basically the casino operator being able to reduce price to us because of the differences in price of those two segments without necessarily affecting the install base. We’ve seen a little bit of that rotation as well. It’s been an interesting year for the install base because actually we really lost a lot of units due to the Class 3 shipments going into Florida and we lost some units because of Class 3 compacting in California as well. The rotation of those units has been mostly into Oklahoma and Alabama. CDS markets there’s been a lot of movement in discreet market. The casino market actually has been reasonably stable. When it comes to game design as an issue which is the first part of your question, a game design is something that we pride ourselves on being the best at. When I remarked on what our video reel share is right now, you should know that we find that to be unacceptable.

I think that a lot of the issue has been the last of a new look and feel presentation to the player and I’ve said that really this June quarter saw us remedy that. We just stuck with that 8960 platform and that look too long. An AVP trim line just wasn’t broad enough for us to stimulate replaced hardware. Having fixed the new cabinets going on seven with MLP I think we get a chance to rectify that. I think that on game designs, we’re very satisfied for instance with the performance of ebay of our MLP business has done extraordinarily well, our ability to support the Wheel of Fortune franchise all demonstrate a pretty good job done with game design

I think that we can say that we have a lot of good titles that generate 25% share into a new environment for video reels, it’s not enough however to support the 40% share that we have of the install base and it’s not enough to support a 40% or better ship share of new boxes. Yes, we absolutely have to do a better job to close that gap and inspire some confidence that we still are the premier game designer including video reels in this industry. I think we probably have a little work and if there’s one area of disappointment, that’s where it sits is a little bit with our video reels production.

Operator

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

William Lerner – Deutsche Bank Securities

Two questions, the first one is T.J. how do you not use your balance sheet which is obviously very underleveraged for all this time to address the video side of the business? We’ve seen you use it for things that frankly don’t show up in earnings or are dilutive in an environment where you need to do accretive things. I understand that there’s a longer term strategy with some of the things that you have used it for, but I guess that’s the first question and I have follow up.

Thomas J. Matthews

Actually we’ve probably done a little bit more there than is visible. The biggest effort that we’ve had at IGT over the last few years is probably more so than people realize as it relates to SB is collaboration with other development groups. For instance, this last quarter the activity we have with PGIC to extend our reach into a couple of markets and to have the opportunity to introduce SB functionality to their casino link install base. That’s important to us. It has been important that some of their development efforts now are oriented toward supporting application development in that space as well.

The same can be said about games. There is kind of a finite number of games that we can introduce in our system and that’s really maybe where we’ve struggled with some internal debate of how many games do we need to publish on an annual basis for us to be able to realize appropriate share. We are constrained by the fact that almost all the game development goes through our development queue which means that however many dollars that we can put in there will define the number of games that we can produce. We are working more with third party game developers than ever before and trying to give them the tools necessary for them to be able to take some of that development work away from us and as a result have the opportunity to publish more title. More titles that have varied looks, different kinds of development styles so we really have a much broader library in that space than we’ve had in times past.

Our issue within video reel realistically is as you know our best ideas still go into game ops. Our best ideas don’t even get into the for sale category. People will mark on that for instance in a market like [McCowell’s], will say how come you’re not doing better there? Well, that’s because none of our best ideas are even available to that market because of the decision of how oriented we are towards game operations. We probably can do a little bit better job of balancing that. If there were ever an acquisition that made a difference in terms of what we think would be the necessary kind of secret recipe or secret formula for developing great games, we would definitely act on it. We haven’t necessarily seen that anybody else has that secret recipe any better than IGT to this point in time though.

William Lerner – Deutsche Bank Securities

The follow up is, and I don’t mean to incite you here, but why would you buy back 6+ million shares of stock in July into an environment when you’re going to guide down essentially for the next three quarters and I would take it one step further, I think it would be helpful to hear you talk about why anyone should bother buying your stock for the next few quarter. You paint a picture of an economic environment that may or may not impact you, it’s the same sort of economic exposure, there’s a lot of other companies that may communicate that differently. You talked a lot about market share and that’s not particularly inspiring imminently, yields are down and that may be a different experience in some of your competitors in this environment. So what’s the point and why would you buy stock ahead of that?

Thomas J. Matthews

Because I think that we still firmly believe in 2010. We still firmly believe that there’s 510,000 IGT machines out there that are ours to replace and that we do have a replacement strategy in place that we can see a meaningful up tick in replacement demand, that we think that the economic conditions that the United States and now around the world are feeling are temporary. I can’t tell you how long temporary is going to last, but they are temporary and you will resume single digit growth in game play levels eventually. You will resume single digit growth in the overall install base of gaming machines both in and outside of the United States that is a good thing for the entire supply side of the industry but really a very good thing for us and we do very well in that category, that you will see game play levels s a result improve in game operations over time, that you’ll see us with the technology and issues that we’ve had.

For instance, remember we’ve opened a pull market with products like electronic Bingo and electronic Lottery and think there’s some other opportunities for us to continue to develop new markets for ourselves, that we think there’s some opportunities for us to go out and find recurring revenue deployments or marketplaces that are more oriented towards recurring revenue. We feel very good about 2010. I wish that we could tell you that we felt a little bit better about 2009 in terms of the immediate environment and I’m hoping that on a future call we’ll be able to tell you that. But I would just say we haven’t had our confidence shaken as to the idea that some of the earnings models out there, including yours Bill, of what you kind see peak earnings is in fact achievable sooner, so all the timeframes that have ever been articulated and when they’ll be accomplished.

Operator

Our last question comes from Rachael Rothman – Merrill Lynch.

Rachael Rothman – Merrill Lynch

This is Ben standing in for Rachael. Of the various factors influencing your guidance cut, can you talk about the ones that are deteriorating the fastest?

Thomas J. Matthews

I’m not sure that necessarily it’s deterioration. The issue was you saw the 2% sequential decline in game ops revenues in an environment that normally would have a 3% or 4% up tick. Some of that mix, but an awful lot just reflecting lower play levels across all markets. Over 80% of our revenue is variable as it relates to our exposure directly to game play levels. I think we have to assume that that persists for a while longer.

I think operating expenses had grown in anticipation of maybe a little bit earlier adoption of some of our AVP units and I think we have now, just given the customers are experiencing these lower play levels, that we should be more conservative in what we think is our ability to stimulate replacement activity near term. We could be wrong on both of those things and have a much better, I guess all three given game ops, replacements and operating expenses were mentioned there, and have much higher performance but until we have better visibility to play levels across all markets, we’ve got to assume that our business is going to reflect somewhat lower activity on an industry-wide basis.

Rachael Rothman – Merrill Lynch

Can you talk a little bit about the ASP in margin profile of the new AVP boxes you’re going to start selling?

Thomas J. Matthews

You see the one thing we’ve done very well is continue to grow margins and we had very good margins in game ops this quarter and that’s in a pretty tough interest rate environment for us. We had something like 325 basis points of interest rate movements over the last six months or so. We’ve absorbed all of that, it hurts our cost of sales but still had a 61% margin in that business over the quarter, had very good margins in product sales. It reflects some of the non-machine mix, it reflects not being in some of the lower margin businesses but also it just reflects in us being able to sell higher margin products to our customers. AVP lowers the margin percentage slightly as it compares to its predecessors but grows absolute margin dollars fairly handily and I think that the decline in the margin percentages are short term.

I think that we will gain manufacturing expertise in that product in a fairly short period of time. We’ll have some of the normal savings that you realize from technologies becoming less expensive over time and you’ll see that 50% to 55% range of margin activity that we’ve had in product sales is going to be well preserved and in fact maybe can even be improved upon.

I think that was our last question for the call. I want to thank everybody for your interest in IGT and being able to talk through what are the outstanding issues facing our business in terms of the economic climate but also be able to remark on the fact that we felt like Q3 was actually a pretty good quarter and wanted to be able to address that as well. Thanks and look forward to talking to you after our fourth quarter.

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Source: International Game Technology F3Q08 (Quarter End 06/30/2008) Earnings Call Transcript
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