Greetings ladies and gentlemen and welcome to the Shuffle Master, Inc. third quarter earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. Gerry Smith, Senior Vice President and General Counsel; you may begin.
Good afternoon and thank you all for joining us today for our third quarter 2008 earnings call. I am Gerry Smith, Senior Vice President and General Counsel of Shuffle Master. With me today are Mark Yoseloff, Chairman of the Board and CEO of Shuffle Master, Paul Meyer, President and Chief Operating Officer and Coreen Sawdon, Senior Vice President, CAO and Acting CFO.
Today’s conference call is being simultaneously webcast through our website, www.shufflemaster.com and will also be archived for the next 30 days. Before we get started I would like to remind you that various remarks we make about future expectations, plans and prospects for the company constitute forward-looking statements for purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from these expectations.
We will also be discussing certain financial measures such as adjusted EBITDA, which represents a non-GAAP financial measure. The importance of this measure to investors as well as reconciliation to the most directly comparable GAAP measures can be found in our most recent 10-Q which will be filed today as well as in our prior public filings including our Form S-1 and in today’s press release which was issued shortly before this conference call announcing our third quarter 2008 results.
Now I’ll turn the call over to our CEO, Mark Yoseloff.
Thanks Gerry, I would like to comment on some recent developments. First I’d like to provide an update on our refinancing strategy. During the third quarter and subsequently we’ve sold equity, increased our bank credit facility with the addition of a term loan component and have tendered for and bought some of our outstanding senior convertible note.
As a result we have strengthened our balance sheet with debt now accounting for less then 2.8x adjusted EBITDA. We can now give our undivided attention to growing the business and move full speed ahead with the next phase of our strategic initiatives.
As far as product strategy at G2E last November we showcased a suite of cutting edge products and table innovations. One of our products that attracted considerable attention was Star Craps; an entirely electronic craps game that enables players to virtually roll the dice, using individual touch screens.
Currently Star Craps is in the last and final stages of GLI approval and should be rolled out within a month. There is significant interest among our customers for this sort of ground breaking technology and we expect this to be an important product in fiscal 2009.
During our first quarter conference call I made reference to an important new concept that combines a number of our hi tech products. This product, the [i-Table], will be introduced at G2E this November. Utilizing touch screen player stations embedded in a standard size blackjack table, the [i-Table] combines an intuitive electronic betting interface with a live dealer who deals selected games from the appropriate Shuffle Master utility product; that is the i-Shoe or the i-Deal specialty shuffler.
By automating the betting process, the i-Table dramatically increases game security, accuracy and speed resulting in an estimated 30% increase in rounds-per-hour while eliminating dealer errors. Further by combining card and bet recognition the i-Table provides table game data including actual win/loss and hand per player while providing accurate player ratings and skill analysis.
Finally the i-Table allows our customers to offer additional wagering such as a true odds bet for blackjack which would be virtually impossible without this technology.
We have previewed this product with a number of our major customers throughout the world and it has been met with considerable enthusiasm.
Turning to the quarter we reported total revenues of $49.5 million, a third quarter record. Diluted earnings per share were reduced to $0.08 as they were negatively impacted by approximately $0.03 per share as a result of an impairment write-down related to our investment in Sona Mobile, Inc. and the expense related to the settlement of a distributor lawsuit.
We experienced solid growth in lease and service revenue in all of our product segments this quarter. Specifically looking at year-over-year increases in lease and service revenue, utility grew from $7.7 million to $8.9 million, a 16% increase; proprietary table games grew from $7 million to $8.9 million, a 28% increase; and electronic table systems grew from $1.7 million to $2.4 million, a 39% increase.
This results in overall lease and service revenue growth from $16.4 million to $20.3 million, a 23% increase and a company record. Now let me turn the call over to Coreen Sawdon to review the quarterly results in more detail.
Thank you Mark and good afternoon to everyone. To summarize our third quarter results, revenue was $49.5 million, representing growth of 10% over the prior year period and 1% over the prior sequential quarter, total lease and service revenue increased 23% to $20.3 million. US revenue was $23.1 million or 47% of revenue, an increase of $2.6 million from the prior year period.
International revenue was $26.4 million or 53% of total revenue, and increased $1.7 million from the prior year period. Operating expenses were $22.1 million, up approximately 12% from the prior year period and up 4% from the quarter ended April 30, 2008.
These increases were predominantly attributable to the weakened US dollar and its impact on expense of the company’s foreign subsidiaries as reported in US dollars, an increase in personnel costs and a non-recurring settlement expense.
We remain committed to and aggressive in reducing costs throughout the entire organization as Mark will elaborate on in his closing remarks.
Adjusted EBITDA totaled $14.1 million for the third quarter compared to $12.3 million from the prior year period. Operating cash flow was strong at $16.8 million, a year-over-year increase of $0.8 million and a quarterly record.
These improvements are the result of a focused effort to reduce inventory levels, manufacturing costs and improved accounts receivable collections. Lastly our effective tax rate for the quarter was 28.7%.
Now I’ll move into a product recap, as compared to the prior year quarter, total utility revenue increased by 6% to $19.96 million. The increase in total revenue for this segment as compared to the prior year period was the result of a 16% increase in lease and service revenue.
Total lease and service revenue was a record $8.9 million compared to $7.7 million in the prior year period and $8.6 million in the prior sequential quarter. Increases in utility lease revenue were principally driven by a 575 shuffle unit increase in our leased install base as well as increases in our monthly average lease price year-over-year.
Sales revenue in this category remained relatively flat from the prior year period. Total shuffler installed base is now approximately 27,500 units, a nearly 2,900 unit increase year-over-year.
Total revenue in the proprietary table games segment were $9.7 million, up 9% from the prior year period despite a sales revenue decline of 61%. Proprietary table games royalty and service revenue reached a record $8.9 million, increasing 28% from the prior year quarter and 9% from the prior sequential quarter.
Royalty and service revenue accounted for 92% of revenue in this segment. The improved royalty and service revenue is largely attributable to an increase in the monthly average lease price per table game from the prior year period driven in part by the addition of table game [bonusing] options to our existing table games and units acquired in connection with the PGIC table game division acquisition.
Moving to electronic table systems, revenues increased 2% from the prior year period and grew significantly from the prior sequential quarter up 20% to $8 million. Although we saw sales revenue decrease 16% year-over-year leasing revenue was strong enough to offset the loss and increased in nearly every product line.
Table Master and Vegas Star product lines grew lease revenues by over 50% from the prior year period. Electronic gaming machines revenue was a third quarter record of $11.8 million, up 25% and 10% from the prior year period and prior sequential quarter respectively.
This year-over-year growth was primarily due to a significant increase of over 50% in the average sales price of our EGMs, which was a result of the growing popularity of several of our titles as well as increased sales of new versus used boxes.
The mix of lease and service revenue versus sale revenue in the third quarter 2008 showed continued improvement accounting for 41% of total revenue compared to 39% and 36% in the prior sequential and prior year periods respectively.
Moving to our margins, gross margin increased to 59% compared to 57% in the prior year period and declined slightly from the prior sequential quarter’s gross margin of 60%. The year-over-year improvement in margin was principally due to a 23% increase in lease and royalty revenue which generally yield better margins over time in addition to higher average lease prices and average sale prices.
The decline from the prior sequential quarter was mainly attributable to increases in amortization over the prior year period and the impact of foreign currency due to the weakening of the US dollar for products built in Austria and Australia.
Lease and royalty gross margin was at 69% for the third quarter whereas sales and service gross margins were at approximately 53%. The higher gross margin numbers associated with leases is yet another compelling reason to emphasize leasing over selling.
Since our last quarterly call, we have executed on the refinancing strategy for our outstanding 150 million contingent convertible senior notes that we anticipate will be put in April of 2009. In July, we entered into a second amendment to our revolving credit facility which provided for a new $65 million term loan which we borrowed against in August.
In July we closed the public offering of approximately 17.6 million shares of common stock at $4.25 per share resulting in net proceeds of approximately $70 million. These net proceeds are included in our cash and cash equivalents at quarter-end.
As part of this offering we granted to our underwriters, and they exercised in August, an over allotment option to purchase 2.6 million shares of common stock at $4.25 per share less the underwriter discount.
After quarter-end we used the net proceeds from the term loan, the equity offering and the exercise of the underwriters over allotment option to repurchase 89.3 million of our 150 million convertible notes at a discounted price of 97.25%.
We used the remaining proceeds from the offering to pay down our existing revolver to an outstanding balance of $6 million. We intend to draw down on the revolver and/or use cash on hand to satisfy the remaining outstanding note of approximately $60 million.
As a result our net debt at the end of the quarter is $127.6 million compared to $230.6 million as of year end, down $103 million of which more then $30 million of this reduction is attributable to our operating cash flow.
Moving to the balance sheet negative working capital as of July 31 is due to the reclassification of our notes to current liabilities based on the substantial likelihood that the holders of the notes will require us to repurchase them on April 15.
Excluding the impact of our classification of the notes in current liabilities and approximately $70 million in cash from our equity offering our working capital would be approximately $66 million. Cash and cash equivalents increased to $89.2 million from $4.4 million at October 31, which includes approximately $70 million of net proceeds from our equity offering which were funded prior to quarter end.
Inventories are $26.5 million, down 22% from October 31, 2007. As mentioned above, these reductions are the result of a formal emphasis on inventory management, improved forecasting and strong revenue performance.
Our general inventory reduction plan includes the following key components: the addition of operations personnel in certain facilities; improved forecasting resulting in better demand planning; and specific inventory reduction goals for operations personnel.
With that I would like to turn the call over to Mark for wrap-up and closing remarks.
Thank you Coreen, on previous calls I have benchmarked our progress against the strategic initiatives first announced 18 months ago. I am pleased with the progress that we have made. One example is the sustained success of the lease model. This quarter marks the seventh consecutive quarter of increased lease and service revenue demonstrating that our strategy is gaining momentum and aligns particularly well with the needs of our customers in the current economic environment.
Eighteen months ago after our acquisition of Stargames there was considerable uncertainty as to the integration of Stargames and with the general lumpiness in revenue as a result of a substantially greater reliance on product sales.
In the intermediate time period we have successfully completed the integration of Stargames as is demonstrated by the contribution of Stargames products to our overall revenue mix and the general profitability of our company in Asia Pac. At the same time we have made substantial progress in stabilizing revenue primarily by reducing our reliance on sales versus leases.
With all of this behind us we must focus attention on improving our ability to move revenue dollars at the top line to profit dollars at the bottom line. As we discussed on previous calls, one of the first ways which we will do this is by reducing manufacturing costs across all of our product lines by engineering cost savings initiatives, as well as improving manufacturing and sourcing efficiencies.
We believe that sustainable gross margins in excess of 60% by the end of 2009 is a realistic and attainable goal. We believe that there is a real opportunity to improve profitability by making meaningful reductions in SG&A without impacting our ability to run our business. Currently we are thoroughly examining our infrastructure with an eye towards taking appropriate action to realize these cost reductions.
Once this analysis is completed we will outline for you the specific strategic initiative necessary to achieve this reduction in SG&A and result in improvements in profitability.
In closing our results this quarter demonstrate that we have made good progress against our goals. We grew revenue, increased the penetration of our key growth products and drove higher ALPs. We continue to make excellent progress on our strategic initiatives.
We are now ready to enter the second phase of our strategy in order to better align our expenses with the current business environment by becoming leaner and more efficient overall. With the debt refinancing successfully behind us we believe that by continuing to execute against our strategic plan as well as introducing appropriate cost reduction and containment measures we will be able to translate revenue growth into greater and greater profitability.
And with that, we are now ready for your questions.
(Operator Instructions) Your first question comes from the line of Ryan Worst – Brean Murray Carret
Ryan Worst – Brean Murray Carret
Could you talk about just the mix of lease shufflers versus sold shufflers in the quarter, it looks like it leaned more towards sales then leases and considering your strategy it’s a little different and different from what we’ve seen over the past couple of quarters?
There’s always some sales activity and this is particularly the case outside of North America and we certainly commented on this. So I think the thing that I am looking at as a metric is the growth of our lease placements every quarter and as you know in the time period when sales were really being pushed hard on us, a couple of years ago, our actual lease placements were reduced over the quarters.
One of the reasons why I think we made the point that in last year shuffler leases are up 575 units year-over-year, 65 units just in the quarter and so there’s no letting up on our desire to lease but of course with international customers particularly the model is just generally sales.
Ryan Worst – Brean Murray Carret
So there were more international placements in the quarter then previous I guess.
Well again, the one area of lumpiness in the shuffler business is the sales in places like Macau, other parts of Asia, parts of Europe where they are sales.
Ryan Worst – Brean Murray Carret
You talked about getting your cost structure in line with the current environment, what are you seeing out there in terms of operator CapEx spending, are you seeing that come down and affecting your business a little bit?
I really don’t. There are isolated examples of individual casino operating companies where they freeze capital for time period, they unfreeze it, they lease instead of buying and they would normally be a natural buyer. There’s a certain amount of that that we see and I think, and I don’t want to suggest that our products are immune to the reductions in CapEx.
On the other hand because our products generally offer operating efficiencies, increased revenues and it’s measurable and it’s immediate, we just don’t see a lot of CapEx reductions when it comes to things like shufflers or a number of our other products. Certainly when we give our customers the choice, I think more of them are leaning toward leasing because of these economic conditions then might have been the case a couple of years ago, but as you said, look there was plenty of shuffler buying in this quarter as well.
The newer products like the e-Tables, we’re trying very hard to sustain mostly leasing although even there there’s been some buying.
Ryan Worst – Brean Murray Carret
On the i-Table product that I guess you’re going to debut at G2E, could you talk about where that it is in terms of the regulatory approvals and things like that and kind of a timeframe and maybe a little more detail on what that product exactly is?
Well the product is exactly what we described. We’re really excited about this product because it combines our electronic table initiatives with our utility product initiatives over the years and you have a fully integrated table solution for our customers. So this involves a dealer and live cards, so that doesn’t change. But what we do have is 100% accurate both card and bet recognition. The betting is done electronically kind of similar to what we do with Rapid Roulette which is very popular already in the US.
But all the outcomes are based on live cards. This can be blackjack, can be baccarat, it can be any of the specialty games like Three Card Poker and so on. The benefits of this product to our customers are so many that I can’t list them all for you but its adding—its additional rounds per time period, no dealer errors, no dealing with chips other than in and out but during game play everything is done electronically.
And from the perspective of the casino customer we can offer them wagering on this device you can’t offer any other way. So for example in blackjack, after you get your hand and you see the dealer’s up cards, we can offer you true odds on your hand or true odds less some sliver for the casino. And we’ve demoed all this to a number of casino operators, big and small, US based and international and the reaction has been overwhelmingly positive. So we’re very excited about rolling this out.
As far as where we are I would say the core development is finished. We wouldn’t be talking about it if it wasn’t. Because this is classified as a table game in almost all markets it will be considered as associated casino equipment as opposed to gaming equipment; same category as an automatic card shuffler and the approvals are generally much quicker then they would be if it were gaming equipment like a slot machine.
Finally we’ve had the regulatory labs in to see the product, several of the key ones not all but several very key regulatory labs, and so I would say that we’re covering a lot bases. We intend to get this in to the labs reasonably soon and are very hopeful that we will be Beta testing live in casinos, hopefully in the next three to six months.
Your next question comes from the line of Joe Greff – JP Morgan
Joe Greff – JP Morgan
What percentage of the year-over-year revenue increase is attributable to weaker US dollar foreign currency with respect to revenue growth?
I would say very little of the revenue increase is attributable to the weakened US dollar and the reason is that so much of our revenue is recorded in US dollars. Even though a sale in Euros might translate into more dollars, there are a lot fewer of those then the other way around where we pay for the products in Euros or Australian dollars and sell in US dollars.
The best example of that is for example in Macau, where we’ve done a lot of selling over the last year, and we sell everything in US dollars in Macau.
Joe Greff – JP Morgan
So you wouldn’t necessarily have revenues expenses match up like for [likeness]?
I only wish it were that simple but the accounting rules don’t permit that and in fact, because of transfer pricing rules amongst our subsidiaries, if we—and a good example is the one2six shuffler that used very heavily in Macau, we sell it in US dollars in Macau, we buy it from our sub in US dollars from our sub in Austria but they purchase the product in Euros and because of transfer pricing rules we actually record substantially less profit now then we used to because of the weakening US dollar.
Joe Greff – JP Morgan
The tax rate was a little bit lower then what we were looking for, was there anything specific there and then what are you thinking in terms of a tax rate to use going forward?
In the third quarter you traditionally do your tax return to provision true-up, you make estimates during the year on your provision and you actually complete the tax return. That’s always something that will always be reflected in our third quarter. It could be favorable or unfavorable depending on our estimates. This quarter it was very favorable for us. We’re expecting that the full year run rate will be south of 35 but north of 30.
Joe Greff – JP Morgan
As you think about those couple of years with some larger North America casinos, a new build full service North America casino, let’s just say on the Las Vegas strip there, there are 100 table games, what percentage of those table games that are potential shuffler opportunities, what percentage of those are opportunities for sale and for lease? What kind of mix do you expect between the two?
Right now what we know in Las Vegas is we know there are particular projects being built here and I would say the answer to that question is as much dependant on who the operator is doing the building as anything else. I think right now we have good opportunities to do leases with many of the operators because they’re trying to keep their capital for deployment in areas where leasing is not available.
And so I know that we’re quoting both sale and lease prices on new projects in Las Vegas but frankly we’re also starting to quote lease prices in Macau where I think some of the operators are coming under some very similar capital issues and leasing may start to look very attractive even in that market to operators when they want to make sure they have the capital to complete the building.
So as far as overall rates, we’re going to get at least half the tables that are being put in new today, at least half of them will have shufflers and of those the mix of sale versus lease I think is still in flux. We’ve done a great job I think of structuring our pricing in such a way that leasing looks great and if the economy continues the way it is, I think leasing will continue to grow even beyond where we are today.
Your next question comes from the line of Bill Lerner – Deutsche Bank
Bill Lerner – Deutsche Bank
In this post elixir environment for you and Asia, can you talk a little bit about your experience so far with back again with RGB, as I recall inventors were concerned about this post elixir timeframe and you wanted to take back some direct sales and resolve some tougher distribution in other parts of Asia and I think you’ve accomplished that, but relatively quietly. So can you talk a bit about that experience, maybe if you want to quantify any of it?
I think the whole issue of our business in Asia has not either been as well communicated or as well understood and I agree with your comment. Much of Asia has been a direct market for us and this includes Macau and it includes a couple of other very key customers in the region and so the issue for us has always been to reach the rest of Asia and that includes very important markets like The Philippines, Cambodia, Vietnam, Laos, and a number of other Asian regions.
We had an agreement for a number of years with RGB. We went away from that agreement; we’ve come back to them. It’s still relatively early in the process in that RGB is a big multi national company, RGB, [Aviati], that whole group, that Dreamgate group. I think they are starting to make excellent progress. They’re starting to move our products in these markets.
My expectations are very high for the next couple of years with them as a distributor because they’re so well regarded, well respected, and frankly have such a presence throughout that region.
So I can’t really quantify but I will qualitatively tell you that I believe we’ve made absolutely the right decision as far as selecting them and that I think in response that the entire RGB, CDI, [Aviati], that entire group is working hard on our behalf and I expect to see great growth in that region because of it.
Your final question comes from the line of Fred Button – Private Investor
Fred Button – Private Investor
I’m a poker player and I notice that when I go to the casinos, every once in awhile I sit at the poker table and I just seem to have quite a bit of problem, red light problem, with the shufflers malfunctioning somehow; cards are bad or something. In our next generation of the shuffler for the poker shuffler, is there any built in thing that’s going to tell you what kind of problems they had or how many red lights they had or how many malfunctions they’ve had during the course of X number of hours?
First I’m sorry to hear you’re having that experience because I think generally these run pretty much service problem free. Right now the shuffler does record every red light and a service tech has the capability to plug a laptop into that shuffler and download the entire history of the shuffler and every time a red light was turned on. And we monitor these very closely.
A lot depends on the maintenance on the product so where we do the maintenance under either a lease or a service contract, we do what’s called [preventative] maintenance; we’re there periodically about once a week to clean and service the unit and those units don’t necessarily have a lot of red lights and sometimes when a casino, on occasion those that choose to do their own self-service perhaps do less preventative maintenance or don’t change the cards quite as frequently as we recommend and so that’s when the cards get a little warped and they’ll jam a little.
But yes we do record all the service log on every machine. We are on somewhere around 70% or 80% of all the poker tables in North America.
There are no additional questions at this time; I would like to turn it back over Mark Yoseloff for any additional or closing comments.
I want to thank everyone for joining us and look forward to speaking to you on our year end call in a few months. Thank you all.
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