International Game Technology Q3 2009 (Qtr End 06/30/09) Earnings Call Transcript

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International Game Technology (NYSE:IGT) F3Q09 Earnings Call Transcript July 23, 2009 9:00 AM ET


Craig Billings - Vice President, Investor Relations

Patrick W. Cavanaugh - Chief Financial Officer

Patti S. Hart - President and Chief Executive Officer


Robin Farley - UBS

Joseph Greff - J.P. Morgan

Steven Kent - Goldman Sachs

David Katz - Oppenheimer & Co.

Bill Lerner – Union Gaming Group

Steven Wieczynski - Stifel Nicolaus

Todd Eilers - Roth Capital Partners

David Bain - Sterne, Agee & Leach


Welcome and thank you for standing by. (Operator instructions) This conference is being recorded. If you have any objections, you may disconnect at this time. I would like to introduce your host, Craig Billings, Vice President, Investor Relations.

Craig Billings

Good morning and welcome to IGT's third quarter fiscal 2009 earnings conference call.

Before beginning, we would like to remind listeners our discussion reflects views based on the marketplace environment as of today, July 23, 2009, and will include forward-looking statements. Actual results may differ materially. Additional information about factors which could potentially impact our financial results is included in today's press release and our filings with the SEC, including our most recent Annual Report on Form 10-K.

During this call we may discuss certain non-GAAP financial measures. In our press release and our filings with the SEC, each of which is posted on our Web site,, you will find additional disclosures regarding any non-GAAP measures, including reconciliations of these measures with comparable GAAP measures.

With that in mind, I’ll pass the call over to Pat who will discuss the current quarter’s results.

Patrick W. Cavanaugh

This morning IGT reported its third quarter results. Our results of $0.22 in diluted earnings per share reflect continued suppressed demand for both our operator customers and their patrons. However, sequential improvements in many categories also reflect our continued belief that the second fiscal quarter marked our operating trough.

Talking about the business divisions, gaming operations first. Our gaming operations continue to feel the impact of challenging marketplace conditions with revenues down 2% sequentially and 14% year-over-year. We earned an average of $52 in revenue per unit per day, a level which has been relatively consistent over the last three sequential quarters, but down from $61 in our last year's third quarter.

Lower year-over-year yields are the combined result of the decline in industry play levels and the growth in the mix of lower yield in stand-alone and lease-operation games in our install base.

IGT's install base ended the third quarter at 61,100 units, up 1,000 units year-over-year but down a modest 200 units compared to the prior sequential quarter. Install base growth in international markets showed continued strength but was offset by reductions in domestic units as our customers continue to look for ways to reduce their expenses in response to the economic slowdown.

While the lower sequential unit count is disappointing, we expect that as the environment continues to stabilize, our install base should resume growth. We are also taking several steps, which Patti will discuss, to rejuvenate our content efforts, which we believe will have a positive impact on our install base longer term.

Gross profit on gaming operations decreased 11% year-over-year but gross margins have remained healthy at 62% for the third quarter versus 61% last year. Margins for this year's quarter did benefit from reduced jackpots stemming from a moderate rise in interest rates, i.e. agencies and Treasuries relative to prime.

In an environment of interest rate stability we would expect to see margins in the 57% to 59% range. Approximately 85% of our install base is comprised of variable fee games that earn a percentage of the machines play level rather than a fixed daily fee.

Moving on to product sales, total revenue was $148.0 million on volume of 7,000 units, this is domestically, for the current quarter compared to $233.0 million and 12, 200 units in the prior-year quarter. Revenue comparisons were difficult because last year's third quarter marked the company's highest quarter of domestic product sales revenues since 2004.

Replacement units shipped totaled 2,300, up 500 sequentially, but down 1,300 from the prior year. While we continue to have limited visibility around replacement demand, we continue to believe future demand will exceed the trough level of 1,800 units we saw in the second quarter.

New and expansion shipments totaled 4,700 units in the quarter, down 3,900 units from the prior-year quarter due to fewer new openings. Last year's third quarter set the IGT record for most units shipped to newer expansion properties. We anticipate new unit shipments will decrease for the next several quarters until some of the more recently approved jurisdictions, such as Maryland, Kansas, Illinois, Ohio begin operations.

Importantly, a new opening shipment of 1,700 units was recorded in this quarter, an event we had originally anticipated to occur in our Q4. We estimate the best impact of this ship to be approximately $0.03.

Domestic non-machine revenue totaled $52.0 million in the quarter, down from $87.0 million in the prior-year quarter, primarily due to lower systems and conversion sales. Domestic deferred revenue increased $8.0 million during the quarter, to a balance of approximately $50.0 million at June 30, 2009.

Domestic average revenue per unit was $22,000 for the third quarter, up 15% from the prior year. Sales of machines utilized in our AVP technology comprised 87% of total North American sales and a trend we expect to continue as our legacy for-sale products are phased out.

International product sales revenue totaled $86.0 million on volume of 6,900 units compared to $111.0 million and 8,000 units in the prior-year quarter. Our international markets continue to feel the effects of the economic slowdown, most notably in Europe.

It's also important to note that approximately half of the units we shipped internationally came from the low-payout markets of the U.K. and Japan.

International non-machine sales were $30.0 million, up from $28.0 million in the prior-year quarter. The quarter was driven by a modest uptick in gaming systems revenue, which are benefitting from our recent PGIC acquisition.

International deferred revenue increased $10.0 million during the quarter to a total balance of $23.0 million at June 30.

International average revenue per unit was $12,600, down 9% year-over-year due to an increase in the mix of the lower priced Japanese units.

Total product sales gross margins for the quarter were 50%, down 400 basis points from the prior, primarily due to the aforementioned increase in the mix of lower-margin Japanese units. Going forward, we expect product sales margins to be close to 50%, assisted by our cost efficiency efforts.

Operating expense, other, and tax. Total operating expense was $173.0 million for the quarter, down from $201.0 million in the prior year. Our cost reduction efforts are beginning to become more evident in year-over-year operating expense comparisons

Just to give you an update on where we're at with costs and rationalization efforts. We have previously announced two rounds of $100.0 million in efficiency efforts. Our initiatives to date have been executed through savings on manufacturing materials, headcount reductions, and non-wage-based expense controls. Thus far, we have completed approximately $135.0 million in annualized cost savings, compared to the fourth quarter of 2008, which was the quarter right before we began these initiatives.

This amount is comprised of $60.0 million from materials savings and the reduction of 484 employees in our manufacturing operations compared to Q4 of 2008 and $75.0 million from the reduction of 303 employees and other non-wage-related cost controls in SG&A and R&D, again compared to Q4 of 2008. Portions of these savings have been, and will continue to be, offset by costs associated with the acquisition of PGIC and inflation.

It is important to note that at our current low-manufacturing volumes, it is difficult to identify the full impact of manufacturing-related reductions in our reported gross margins. We would expect to see the impact of these adjustments as volumes return.

Additionally, in the near term we would expect our SG&A, exclusive of bad debt provisions, to be approximately $100.0 million per quarter and R&D to remain in the low $50.0 million area.

The remainder of our announced cost-saving efforts are being identified during our 2010 planning process, which is currently underway, and they will be implemented throughout the next fiscal year, thus we would expect to see the complete impact of our adjustments in Q4 of 2010 and we will update you in the future when it significant portions of such efforts are implemented.

SG&A, excluding bad debt, these previously mentioned cost savings, coupled with declines in other items, resulted in a year-over-year decline in SG&A of $21.0 million, or 18%. $96.0 million for the quarter.

R&D expense totaled $52.0 million for the quarter, which is down $6.0 million, or 11%, from the prior year.

Depreciation and amortization within operating expenses totaled $20.0 million for the quarter, which was up approximately $1.0 million quarter-over-quarter.

Bad debt provisions for the quarter totaled $1.0 million compared to $4.0 million in the previous year. The favorable change stems from the collection of previously reserved receivables from certain international customers during the quarter.

We continue to prudently reserve against our outstanding customer balances in response to the challenging economic environment but we have not seen any meaningful increases in delayed payments.

Total depreciation and amortization is reflected in our cash flows, with $64.0 million, in line with last year's quarter. Total D&A includes depreciation on our game ops assets recognized in the margin. The year-over-year decline was mostly due to a larger base of fully-depreciated assets in the quarter.

Other income and expense net in the quarter was a net expense of $17.0 million, which is up from an expense of $5.0 million in the prior year. The increase was mostly due to higher borrowing costs as a result of an increased debt balance and higher interest rates as well as one-time costs related to our recent debt refinances.

Our tax rate was 37.9% in the quarter compared to 40.4% in the prior-year quarter, due to discrete tax items. Going forward, we expect our quarterly tax run rate to trend at approximately 39% to 40%, excluding discrete items.

For fiscal 2009 we would expect our annual tax rate to come in between 33% and 35%, primarily due to the impact of large discrete tax items recognized earlier this fiscal year.

Moving on to the balance sheet, cash, equivalents, and short-term investments, inclusive of restricted amounts, totaled $282.0 million at June 30, 2009, compared to $374.0 million at September 30, 2008.

Debt totaled $2.3 billion at June 30, 2009, comparable to the balance that was there at September 30, 2008.

Working capital totaled $723.0 million, down slightly from $733.0 million as of September 30, 2009.

Average days sales outstanding, excluding receivables from our development financing loans, was 86 days, up from 78 days sequentially, mainly due to shipments to new casino openings.

Inventory turns averaged 2.7x, down slightly from 2.8x in the sequential quarter.

Year-to-date we have generated $354.0 million in cash from operations, down slightly from $361.0 million the prior year. Cash flow in the prior year was burdened by additional prepayments for long-term licensing rights and the current year has benefited from reductions in our receivables and inventory balances.

Capital expenditures totaled $176.0 million year-to-date compared to $222.0 million in the same period last year, due to lower investments in TT&E following last year's completion of the Las Vegas campus.

Capex is expected to trend in the quarterly range of $50.0 million to $75.0 million, although we continue to come in near the lower end of the ranges. We more proactively manage our capex as part of our efficiency and cost reduction efforts.

As we have previously announced over the course of the third quarter, IGT engaged in three transactions which completed the refinancing of our balance sheet: our 3.25% convertible notes; our extended credit facility agreement; and our 7.5% notes, which secured our liquidity needs for the foreseeable future at very attractive rates and afford us the financial flexibility necessary to fund our business consistent with our operating strategy.

Summarizing our balance sheet, post refinancing, today we have total debt of $2.3 billion, comprised of $850.0 million on 3.25% convertible notes, $707.0 million of our 2.6% convertible notes, $500.0 million of 7.5% notes, and $239.0 million drawn on our line of credit, which has approximately $1.6 billion available for use.

We anticipate drawing on our line to fund the put of our 2.6% convertible notes, which is likely to occur in December of this year.

I would encourage anyone with questions on the changes in our capital structure to reach out to us for additional explanations as our refinancing, as well as the adoption of an accounting pronouncement in the first quarter of fiscal 2010, may meaningful impact the reported amount of interest when compared to prior periods.

That concludes my prepared remarks regarding IGT's quarter. Thanks for your time and attention. I will now turn the call over to Patti for closing remarks.

Patti S. Hart

Last quarter we conveyed to you our belief that our business had reached a trough in the midst of very difficult markets. Today I would like to reiterate this view and highlight some of our positive developments from this past quarter.

At 2,300 units, our North American replacement sales improved 28% from the prior quarter. Those operators who are able to allocate capital are doing so at a higher, yet measured, rate, striking a balance between conservative capital deployment and the recognition that their slot product is need of refreshment.

We continue to experience broad adoption of our new products and platforms, with AVP comprising 87% of our North American sales. We also shipped 920 MLD units in the quarter.

In gaming operations, our yields have continued to hold at near $52 per unit per day, indicating a continued stabilization of play levels. We view this stabilization as a positive leading indicator as our customers enter their 2010 capital budgeting cycles.

We continue to successfully pursue additional placements for our Mega Jackpot products and although not a third quarter event, we have recently reached agreements with two of the largest casino operators for the placement of over 450 Mega Jackpot and Wheel of Fortune machines, over and above the existing units on their floors today. These agreements speak to the irreplaceable power of our Mega Jackpot and Wheel of Fortune products and you should expect to see more formal announcements on these wins very soon.

So while we await a more dramatic increase in industry play levels and sector-wide replacement demand, the third quarter was characterized by noted improvements in product sales, stability in yields from gaming operations, and improved customer sentiment compared to earlier in the year.

We moved forward on a number of other fronts in the quarter, hiring key executives, including Chris Satchell, our new chief technology officer, and Eric Tom, our new executive vice president of North American sales and marketing.

We successfully refinanced our balance sheet and now have a series of staggered maturities and ample liquidity.

And finally, we are extremely pleased with the legislative developments during the quarter and look forward to the impending revenue opportunities in expanding jurisdictions such as Illinois and Ohio.

I have now been the CEO of IGT for 113 very active days. I have traveled the domestic and foreign markets to meet with our business unit leaders, I have met with many of our valued customers, I have met with many of our largest shareholders, and I have met with our primary competitors. Through all of this I have gained a deeper understanding of the processes and methods used to execute our business strategy, as well as multiple perspectives on our competitive position.

As I have gained a better grasp of where we stand, my strategic priorities for the business have become increasingly focused. In our previous call I mentioned three key areas of business that I was seeking to better understand. The first was our need to focus on what we do well. For many years IGT has been an industry leader in gaming content around the world. Content is what has traditionally distinguished us, yet today we face a market of highly capable competitors in the ending gaming patrons and increasing game complexity.

Such a market requires constant enhancements, innovations, and improvements to the quality of our content across our product portfolio, but particularly in the video slot segment.

Excellent content drives product sales, increases our participation in the replacement cycle, and importantly, grows our install base. To that end, we have implemented specific efforts to enhance our content offerings.

First, we are restructuring our product efforts into a series of focused verticals comprised of individual business owners and dedicated studios, allowing us to better manage the economic contribution of various components of our business.

Our core product management and development teams are being divided into three areas: gaming operations; for-sale products; and systems, all with a shared engineering platform. This new structure allows us to drive accountability to those individuals that are tasked with delivering products to the market for their specific areas.

In addition, we recently implemented a consumer research group designed to aggregate and analyze patron-level data in order to feel the R&D process with real-time market information, making the patrons the focus of our development efforts.

As our recent product introductions, such as MLD, and our talented development studios acting as strong tailwinds to these efforts, I am optimistic about our ability to more quickly respond to changes in the content environment with a high-quality product.

Included in our most recent workforce adjustments was the elimination of certain senior level gatekeeper positions which previously served as intermediaries between the critical functions of game development and product design and delivery. I highlight this as an example of my second point from our previous call, increasing the velocity of decision making and expediting delivery of product to the market.

In my short time as CEO I've had the opportunity to review our operating results from 2004, which was a banner year for IGT. Comparing the operating environment in which those results were achieved to the operating environment of today has provided me with a basis for my plan to return IGT to an appropriate level of efficiency.

The reality is that our organization has grown much more complex, partially in response to a more complex market which demands more products and greater customization, but also of our own doing through the addition of platforms and acquisitions. While market complexity is a fact of life we must live with, IGT-induced complexity is not.

Structural adjustment like the elimination of layers between development and design will improve the velocity of our decisions while reducing costs. Changes such as these will be implemented relatively quickly. However, other changes will take time. We will reduce internal complexities through rationalization and combination of delivery platforms and the streamlining of internal processes. These efforts will reduce our time to market, enhance the effectiveness of our R&D efforts, and ultimately improve our margins. While this is a process well-suited to my operating style, it is a process which will take time and diligence and will play out over the next several years.

The third point I mentioned in our previous call was the implementation of specific measurements to gauge the results of our efforts earlier and more often. I am a big believer in metric-driven management and the clarity that it provides. My goal is to allow our corporate managers and executives to review up-to-date and relevant data and derive quicker decision making and have the evaluation of their performance tied more directly to those decisions.

I have focused my efforts here on two key areas. The first area is the aggregation and summarization of business information provided to management from the manufacturing floor to the boardroom.

The second is the utilization of that information by key decision makers to maximize the return on capital. My initial analysis has led me to the conclusion that while IGT's powerful business systems gather many of the key components of the information base, we can do a better job of summarizing, analyzing, and acting on that information in real time.

A number of projects are already underway, which will ultimately impact many aspects of our business, from the way we field test our new games, to individually tailored compensation metrics, to investment in capital allocation decisions.

Joining me in the process of designing structures to more effectively manage our business is my recently hired chief of staff, Robert Melendrez, who is responsible for the aggregation, interpretation, and application of the key indicators of performance within IGT. Through our efforts we intend to maximize the efficiency of our deployed capital, including any areas of research and development, inventory, and capital expenditures.

In summary, my initial goals continue to focus on the pursuit of superior returns through continuous enhancement of content delivered across all of our platform, whether it is through the deployment of our server-based architecture on a full-floor or modular basis, or in the sale of individual gaming machines. In any case, it will be done in the most capital-efficient manner possible.

I am positive that the steps we are taking will help us to achieve these goals. I will continue to evolve and refine my focus and as time goes on and market conditions change I will proactively shift our initiatives as necessary. And above all, I will communicate with you throughout that process.

Fortunately, I have come into this position with very many valuable tools at my disposal: the industry's leading game developers, a capable and knowledgeable employee population, a business that enjoys robust cash flows, and a solid customer install base. Working from this position of strength, I could not be more optimistic about the future of our great company.

And now on to our outlook for the remainder of 2009. On the top of the cost reductions, as Pat mentioned, we are currently working through our second $100.0 million of savings that we've made great progress. As you know, we regrettably announced some staff reductions two weeks ago. While we're always unhappy to part with employees, the current operating environment requires these difficult and painful decisions.

While we have made great progress, we continue to look at every aspect of our business in search of greater efficiencies. Despite improvements in several key metrics during the third quarter, we will still await a clear and discernable trend in replacement sales. While we continue to expect near-term improvement from trough levels, we will remain cautious until we see sustained incremental replacement demand, both domestically and internationally.

Additionally, as Pat noted, we recorded $0.03 of earnings this quarter which we expected to recognize in the fourth quarter.

As a result of all of these factors, we are adjusting our guidance for 2009 to a range of $0.75 to $0.80, inclusive of the incremental financing costs we began experiencing in the third quarter.

That concludes my remarks and we would like to open for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Robin Farley – UBS.

Robin Farley - UBS

I wonder if you could give us a little bit of color on where you think your market share, domestically, was this quarter in product sales.

And then also a little more color behind the sequential reduction in the domestic revenue sharing units.

Patrick W. Cavanaugh

Market share for the quarter, as you computed, we have not yet computed it, until everybody reports their results and given that we're the first one out of the gates, we don't yet have a computation on it.

But my guess is it's probably going to come in some place close to where it's been the last couple of quarters.

And regarding the reduction in game ops assets during the quarter, I think what you've seen is an ongoing trend over the last twelve months or so, maybe 18 months, of operators trying to figure out what's the right mix on their floor of those assets to maximize both their revenues but also minimize the costs that they spend.

And the agreements that we recently entered into, which we've been working through with most of our large customers to get those assets back on their floors, I think are evidence that those assets earns their way onto those casino floors.

So I think the sequential reduction in units is really just more of a timing issue. You know, we churn a lot of assets in and out of that install base on a monthly and quarterly basis.

Robin Farley - UBS

When you talked about the large operators you expect to announce agreements for I think it was 450 units, do you expect then the September quarter to end up being a sequential uptick or downtick on a net basis, with all the admin remove?

Patrick W. Cavanaugh

At this point, we're going to fluctuate up and down slightly. I think you are apt to see a relatively stable install base at around 61,000, 62,000 units, in that range.


Your next question comes from Joseph Greff - J.P. Morgan.

Joseph Greff - J.P. Morgan

I was hoping you could help us, from where you sit and as you understand things, how you're thinking about the timing of the opportunities in Ohio and Illinois.

And then along the idea of talking about opportunities, I was hoping you could give us an update on what's going on in Mexico and Italy, how you are thinking about what the potential size of those opportunities are and any timing on those markets.

Patti S. Hart

I'll let Pat talk about Mexico and Italy a bit, but I think in all cases, and I'll ask Pat to add more color, I think we're in the process of really working through translating the legislative work into what it means to our business. The process between making the decision politically and actually deploying product is always a process that we work through and I think there are still refinements being made.

We believe in the locations that you indicated, there is substantial opportunity for IGT and we're putting together plans to capitalize on that, working both locally with the legislative bodies to interpret the actual documents, and then also converting that into product needs and delivery of product over time.

But I would say that it is a work in process. I think that the bills are not concluded yet and have not been completely translated, however we believe it's a significant opportunity for us.

The same in Italy. We're, again, working through it. It, again, has some complexity in how we get the product to market but we think that our product is very well suited. If you look at our Cyberview product and the deployment of that in the U.K., we think it's very well suited for the requirements that the Italian market has outlined.

Patrick W. Cavanaugh

Just to add on for Mexico, and really similar for Italy, those are two markets that have been evolving from historically what we would refer to as gray markets, where we really can't participate because it wasn't clear as to whether it was legal or illegal, to now they're becoming mainstream markets.

You know, in Mexico you saw them first go to a Class II type of product, now they're toying with the idea of can they move to a full-blown Class III product.

And you see similar movements in Italy where that market, from less than 10 years ago, was a gray market that had approximately a million video poker machines, then they experimented for the last five or six years with an AWP product and now are moving to more something akin to a Class III product but that is centrally monitored so that the government knows that it's getting its fair share.

Craig Billings

And just to quickly size that market for you, it's probably about 300,000 AWPs now, white market AWPs now. 14% of those AWPs can be converted to DLTs. So that should give you a sense for the addressable market.


Your next question comes from Steven Kent - Goldman Sachs.

Steven Kent - Goldman Sachs

Two questions. First, on some of your cost reduction program is up. Patti, maybe you could just talk about your view on this over the next 12 to 24 months about how you're looking at things. What I'm after is are there really any sacred cows our there? Are you looking at everything, from spinning businesses off or selling businesses to closing down businesses? How sort of top to bottom are you looking at the cost/expenditure program?

And then separately, I was interested in what you had to say about some of your product design people and the refocus there. Are we going to see maybe some evidence of this maybe by G2E in November, maybe some even prototype or discussion of what you potentially have?

Patti S. Hart

First of all, it's a very good question and there are no sacred cows in the analysis that we're going through. We are looking top to bottom in the company. As Pat indicated, we've really been successful I think relatively quickly in extracting $135.0 million from the business.

But we have room to go and it's less about just pure costs, from my perspective, and it's more about a real focus on efficiency, to really moving ourselves to a point where we have clearly prioritized products and clearly prioritized projects and that we really are increasing the speed to market.

And we're coming to market with more of a market-focused beginning. So we're trying to reorganize—not reorganize on an org chart but reorganize our thinking—from the customer in. So there are no sacred cows, we will look at all of the things that you indicated and will really focus ourselves on those products, those projects, those markets that are contributing the most to the bottom line of the company and we'll find other ways to serve outside of that range.

So the answer to your question is there are now sacred cows, and yes, we're looking at everything. But it will take some time because moving from really just eliminating cost bloat, where is really where we've been finding ourselves, to now finding efficiency in the business, is just a different process. And so it will take us a bit more time to make our way through there.

And I forgot your second question, I'm sorry.

Steven Kent - Goldman Sachs

New products.

Patti S. Hart

So yes, our expectation is hopefully between now and G2E you'll start to see some of the work. Keeping in mind our product development process is run in excess of a year, so we're kind of running over a year in kind of from idea concept to actual product in the marketplace. I think that we have been able to accelerate through things that were in process when I joined the company that we think will be large contributors, so I think you'll see some of those come to market early with some hard work by our workforce.

And I think you'll start to see the signs of the focus. It'll be clear to you, I think, what our focus will be going forward from a product perspective.


Your next question comes from David Katz - Oppenheimer & Co.

David Katz - Oppenheimer & Co.

I just wanted to make sure I heard, Patti, your answer to the previous question. So by this G2E we should see a little bit of strategic clarity in terms of product, right? There are some things in the pipeline that we'll get a good look at?

Patti S. Hart

Yes, there are some things in the pipeline and so I think you'll see some finished product that will begin to provide clarity. But I think you'll also, your meetings with the company, start to really understand what will be on the front burner for IGT as we go forward.

David Katz - Oppenheimer & Co.

Can you talk about your strategy for R&D. There is obviously a lot of discussion about cost cutting, etc. Should we be expecting that number to go up, down, or stay flat?

Patti S. Hart

Again, I think of R&D as an investment, and an investment in building new products for our customers. So my expectation is that you should expect to see the R&D numbers stay relatively flat. I think a couple of changes that I would like for you also to see over the coming time, and that is, more efficiency, more conversion of the R&D spending to revenue generating products.

So we talked about the creation of our consumer research group, and I think you'll also see us moving our testing up earlier in the process so that we're committed to abandoning projects earlier that are not going to make into the market.

So what I would like to do is find that I'm delivering more products and better performing products to the market for the same R&D dollars that I'm spending today.

David Katz - Oppenheimer & Co.

Is there any strategy in terms of reallocating that toward slot product versus systems, or is this sort of one big strategic view at the moment?

Patti S. Hart

Again, I think part of, which maybe wasn't as obvious in my comments, I think part of our shift in our thinking is really kind of putting our game experience out front and then thinking about the R&D, whether it's associated with systems or it's associated with applications, kind of behind the notion of improving the experience for the patron.

So I don't think about it as allocation of R&D across units. I think about allocation of R&D with the prioritization being improving the gaming experience for the patron, and the game plays for casino operators. So that's how we'll think about allocating it.

We're in the process of, not completed yet, in deploying the creation of these business units so that we can measure the contribution of gaming ops business, our for-sale business, and our systems business. But the underlying engineering resources, which is where the R&D comes from, will apply across those based on prioritization of improving the gaming experience for the patron.

David Katz - Oppenheimer & Co.

Do you expect that when you report going forward that those line items that have been non-machine sales, is that going to be reported as a systems business line the way competitors do it or do you expect to keep doing it this way. Obviously because we're always looking to try to compare and contrast?

Patrick W. Cavanaugh

I think yet to be determined. The jury's still out. That's an internal debate that's currently underway and I think a lot of it will depend on how material the numbers become over time. It's really defining it as is it a product sale or is it a true recurring revenue, I think will be the determining factor. But my guess is that some point in the future we will have to make some slight adjustments to our P&L to bring a little more clarity to that.

David Katz - Oppenheimer & Co.

One of the non-recurring items was referred to as breakage. What is that exactly?

Patrick W. Cavanaugh

We paid some fees in connection with the refinancing line of credit to early terminate some previous draws that we had. So it's debt breakage fees.

Craig Billings

Fees that we had to pay to the member banks in our line of credit to break those draws short. We take draws that are 60, 90 days, etc.


Your next question comes from Bill Lerner – Union Gaming Group.

Bill Lerner – Union Gaming Group

On MLD, can you talk a little bit about how this quarter, I know we're talking about a low base so it's almost silly, that's obvious, but just so we can start extrapolating, how might that have shown up this quarter, whether it was in share or in pricing?

And Pat, you mentioned this change in development strategy toward studios. Over the last literally decade I've heard you talk about redesigning your development strategy a countless number of times, with particular individuals running things and then in running studios and not running development. I'm thoroughly confused. I guess the question is what's different about your vertical or horizontal development strategy than has been in the past.

Patrick W. Cavanaugh

On MLD, out of 7,000 domestic units roughly that we shipped during the quarter, just under 1,000 of those were MLD. And it's clear when you talk to customers, it is an in-demand product.

And it's also what was driving ASPs for the quarter. Domestically our ASPs came in, some over 14,000 which is up both sequentially and quite noticeably year-over-year.

Bill Lerner – Union Gaming Group

What's MLD premium to normal video, roughly?

Patrick W. Cavanaugh

Probably about 3,000 to 4,000 I'm guessing.

Patti S. Hart

On the design, and I appreciate that when you hear from us we're always more focused on changing because they impact us more than it's obvious to you, but this is a pretty C change in the way we think about our business at IGT. We have historically managed our product development process through a very functional organization where we had engineering and game studios and product development as units that really addressed a broad base of products. And as the number of products that we provide to the market and the complexity of those products has grown, the ability really to provide the speed to market in that kind of a structure was a real obstacle for us.

So we have completely broken that apart and created stand-alone business units that address our gaming ops business and our for-sale products business and our systems business, and those organizations will be measured on the financial contribution of their products. They will be responsible for managing the costs of their products. They will be responsible for setting pricing in the market for their products. They will be responsible soup to nuts and utilize one distribution channel to put their products into the marketplace.

But it is a real C change for the way we think about the company, starting to measure our self down at the product level as opposed to at the functional level, which I think will drive a greater accountability and will definitely increase speed, that you have fewer high-level gatekeepers thinking about—you have no gatekeepers, you only have people owning the business—thinking about how we improve the performance of this particular product in the market.

Bill Lerner – Union Gaming Group

On Japan, I think we are probably almost to the day a year away from the beginning of the Reg 5 expiration. And it sounds like you shipped some units into Japan this quarter relative to none or very few in the past. What are you seeing or hearing, if anything, on a Reg 5 amendment and how are you thinking about that obviously big opportunity if it comes to bear.

Patrick W. Cavanaugh

That's true. Unfortunately, we're not seeing a lot of clarity there on any adjustments to Reg 5. And so until we do I think you're going to see a market that's going to remain very unpredictable, which it has been for the better part of the last two years where it's hit and miss. While we sold some units in there this past quarter, it was a nominal amount. I want to say it about 1,200 units, so it wasn't anything to write home about.


Your next question comes from Steven Wieczynski - Stifel Nicolaus.

Steven Wieczynski - Stifel Nicolaus

Can you break out the other income line for me?

Patrick W. Cavanaugh

Other income. We had interest income of $15.1 million, interest expense of $32.2 million, and then other to get you to a net expense of $17.0 million.

Steven Wieczynski - Stifel Nicolaus

And something that hasn't really been discussed too much on the call yet, but in terms of server-based gaming, what has your feedback been so far from customers. Is everybody just kind of waiting for the opening of Citicenter to get a better handle on the product at this point?

Patti S. Hart

First of all, I would say the partial floor deployments, I call them modulars, so I'll call it a modular deployment of the server-based gaming products has received very good feedback. We are working closely with the customers. We're in the process of deploying additional modular installations. So I would say the feedback has been very positive.

Obviously when you go through a system deployment, like we are, unfortunately, in my career I've been through a lot of these system-types of deployments. I mean, as you go through that you work yourself through bugs. If you hold a product until all the bugs are worked out the market will pass you by so you put it out there and you work through it. And so we're working through that with the customers.

We're all waiting for the installation at Citicenter. We're in our test right now at Monte Carlo with them. Again, we're working through the bugs there. It's kind of all hands on deck at IGT. I'm getting daily updates from my team so I'm very involved in what's going on there.

That's a very critical deployment, not just for IGT but for the industry. I mean, it's really, from an interoperability perspective, this is really the beginning of a big change in our industry, so we're looking at it.

Like I would say, the early return is very good. There will always be bugs. We have those identified and we work through them very quickly and our real goal is to really get to a very clean product that can be deployed rapidly and on a broad basis.


Your next question comes from Todd Eilers - Roth Capital Partners.

Todd Eilers - Roth Capital Partners

You mentioned that product sales in the quarter, you mentioned a new property opening that the shipments were pulled forward into this quarter that you were expecting in the fourth quarter. Can you tell us which property opening that was or what market that was in?

Patrick W. Cavanaugh

It was the firekeepers in the Midwest.

Todd Eilers - Roth Capital Partners

And I believe that was a total of 2,500 units for their entire casino, so you got what, about 68% ship share?

Patrick W. Cavanaugh

I think it was about 1,700 units, if my memory serves me right. And at the time we forecast that way back when, because we're selling them the system. You know, the normal course is you don't always have revenue recognition criteria met to segregate the two and it turns out that we actually did, so that's what led to the recognition of that in Q3.

Todd Eilers - Roth Capital Partners

Clearly there are certain operators that are still in a tough spot and there are certain markets that are seeing substantial declines in revenue. Can you talk a little bit on the replacement side which markets, what types of customers are you seeing the majority of your replacement sales coming from right now?

Patrick W. Cavanaugh

Generally it's outside of Las Vegas and Atlantic City, I think is a fair assumption. And I think pretty consistent throughout most of the river boat, Native American community. So it's obviously some notable exceptions in there but I think for the most part, really outside of those customers that are the most capital constrained at this point.


Your next question comes from David Bain - Sterne, Agee & Leach.

David Bain - Sterne, Agee & Leach

First, to follow-up on Todd's question, the Firekeepers, the ASPs, can you review that, maybe break it up between new casinos versus replacements.

Patrick W. Cavanaugh

Sorry, but I don't have that level of granularity in front of me.

David Bain - Sterne, Agee & Leach

With Firekeepers, were you with involved in the financing at all or was there some sort of because it was a fairly percentage and I remember there were, early on, some negotiations there.

Patrick W. Cavanaugh

No. I'm not sure who it was that financed it but we weren't involved in the financing.

David Bain - Sterne, Agee & Leach

And on cost cuts, I realize there is no overall benefit to the company's bottom line, at some point are we looking at higher EPS and maybe a lower revenue base than if we had not cut costs and will the company be positioned, when the overall market improves more dramatically?

Patrick W. Cavanaugh

Yes, I think that's the whole effort here, is really about—not so much about costs, I mean, don't get us wrong, we had too many costs, but the real issue, to Patti's point, is this effort is really about efficiency and making us much leaner and more responsive and friendlier to do business with and all of those things, that in theory should pay dividends when we see an uptick in the top line.


There are no further questions in the queue.

Patti S. Hart

Well, we thank all of you for joining us this morning and thank you for your questions and we look forward to chatting in the future.


This concludes today’s conference call.

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