International Game Technology PLC
Q2 2008 Earnings Call Transcript

Published: 18 Apr 2008

[Operator:]

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

[Patrick Cavanaugh:]

Thank you, operator and good morning. Welcome, everyone to IGT’s second quarter fiscal 2008 earnings call. Joining me today are T.J. Matthews, our Chairman and Chief Executive Officer; and Danny Siciliano, our Chief Accounting Officer and Treasurer. Before we begin, I’d like to note that during this earnings conference call certain statements and responses to questions may contain forward-looking information, including forecasts of future financial performance and estimates of amounts not yet determinable; the potential for growth of existing, and the opening of new markets for our products; play levels for our install base of recurring revenue games as well as our future prospects and proposed new products, services, developments or business strategies. Actual results could differ materially from those projected or reflected in our forward-looking statements. Already reported results should not be considered an indication of future performance. IGT’s future financial condition and results of operations as well as its forward-looking statements are subject to change and to inherent known and unknown risks and uncertainties. IGT does not intend and takes no obligation to update our forward-looking statements, including any comments regarding our earnings expectations to reflect future events or circumstances. All forward-looking statements made in this conference call reflect IGT’s current analysis of existing trends and information and represent IGT’s judgment only as of today. You should not assume later in the quarter or the year that the comments we make today are still valid. Actual results may differ materially from the current expectations based on a number of factors affecting IGT’s businesses, including

[Thomas Matthews:]

Thank you, Pat and good morning to everyone. Before we open the line for questions I have a few comments that regard our business and the outlook here at IGT. While this was a disappointing quarter financially, we still made progress in achieving our long-term objectives. We had new products that began shipping in this third quarter, and our anticipated new cabinets have delayed some of our customer orders, with them expecting to take part in our latest offering. Of course we continue to concentrate on introducing new game themes particularly for the AVP, that’s a real core strength here at IGT. We made several deals during the quarter which move us further along the path to successful deployment of server-based gaming. This morning we announced a deal for CityCenter. We also had previously announced the orders that we have for NexGen with Harrah’s, the strategic partnership established with WMS and that with PGIC as well. We also announced this morning through our Barcrest subsidiary a partnership with the Global Draw and Games Media in the UK, and then we have the pending potential transaction of CyberView. All of these should help us with our SB efforts as we continue to make progress on the timelines that we previously announced. To remind people of those timelines, ‘07 was really the introduction of the concept to the marketplace

[Operator:]

The first question comes from David Katz - Oppenheimer.

[David Katz:]

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

[Patrick Cavanaugh:]

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

[David Katz:]

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

[Thomas Matthews:]

They are. More than 50% of our shipments in this last quarter were AVP related, and we expect that that percentage is going to grow in the back half of the year. We have the normal issues with introducing new products to the marketplace. You freeze some purchase activity, I think that’s probably a little bit about what happened with the numbers in Q2 and you have, of course, the risk of getting timely approvals for the cabinets, the hardware, the underlying platforms, the games to be deployed on those. So there’s certainly some timing elements that we still need to get through in Q3 and Q4. But we feel very good about the products that are to be introduced. All of those of course make floors SB-ready as they are deployed, and so far have been very favorably received as we present them to our customers. As a result, our backlog is up a great deal quarter over quarter.

[David Katz:]

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

[Thomas Matthews:]

Sure. If you remember, there are a number of system products that we already deploy into the market that there really is no development associated with. That includes Advantage. Advantage is patron management, includes bonusing, the back of the house accounting. That will remain as it currently is operated for CityCenter and for other new installations. There’s also our Table ID piece, there’s the opportunity for us to obviously introduce ticketing, and at CityCenter we may have an opportunity to deploy Mariposa as well. We continue to explore that opportunity. So really what we’re doing is layering on top of that the SB functionality. The SB functionality timeline goes like this

[David Katz:]

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

[Thomas Matthews:]

Well, for the most part the team remains as it’s been; SB applications and the definition of the product have been led by a fellow named Rich Schneider for all this time. Rich Schneider came to IGT with the acquisition of Acres Gaming back in 2003. He was President of Acres, managed integration of our systems businesses between the two respective companies, and for the last couple of years has had the responsibility of overseeing SB. He really has played the pivotal role of going out and helping us secure customer agreements and some definition as to what the first phases of the product needed to be. Of course has been integral in the kinds of cooperation that we need from our peer companies as well and so he’s been helpful to that as well. So from that perspective, there have been no changes. We did have a fellow by the name of Andy Ingram who was in charge of all networked gaming systems for us

[Operator:]

Our next question comes from Steve Kent - Goldman Sachs.

[Steve Kent:]

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

[Thomas Matthews:]

So to answer the first question about replacement sales, we’ve remarked in the past about the fact that we perhaps over-penetrated the market in the wake of EZ Pay deployment, that we were early adopters of that technology and had an advantage with that first mover positioning. As a result of that, there’s been some recalibration of floors. I think it continues to show itself in shift share to replacement opportunities, in that that’s lower than what is our historical install base. I think some of that is result of our own activity. I think the slowing down on replacements in some instances is an easy decision for deferral of CapEx by our customers, probably less that they’re affected by the economy but trying to understand whether or not they will be affected by the economy for an extended period of time as well as some of their own capital structure issues as a result of their access to capital given the change in the credit market. I certainly would be remiss to say that there was no competitive impact; there is. Competitors are doing a better job right now, both having access to current technologies and doing a better job with their games. I would say that we would never use that as an excuse, though. I mean, it’s our job to go out and secure 60% plus of the floor. If you take a look at new properties, which is really still to me the beacon of our strength, you see that we still accomplish those kinds of penetration rates when places open. So I feel very comfortable about what our competitive standing is, understand that on the margin in the replacement environment that we have slipped a bit but it is with these new products that we are introducing this quarter, the biggest effort ever in the history of this company for introducing new cabinets, new platforms, new games, all in advance of this very industry-changing technology that we call SB. I feel very comfortable that we are going to start growing our share of replacement demand and in fact can start simulating some replacement demand. But the economic factors that cause the timing to be determined are in the hands of the operators, not ourselves.

[Steve Kent:]

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

[Thomas Matthews:]

I think that the primary impact on play levels this quarter is seasonality. That’s why they’re up sequentially. But that year-over-year comparison, I think really going into the quarter we would have expected a slightly bigger uptick due to seasonal factors and as we started measuring both directly, since we can with our wide area progressive systems and indirectly, just seeing some of the results of the market, there’s no doubt that play levels maybe weren’t as robust this year as were hoped for. Our games work because they’re the most popular, and so we’ve always said that we think they’re the first games played and the last games to stop being played. And so, yes, I mean, we think that our products probably are slightly less impacted by the overall economic impact on play levels than are other of our nonparticipation games. But that said, if there’s less total spend going on in a casino environment, our games are going to be included in that.

[Operator:]

Our next question comes from Joe Greff - Bear Stearns.

[Joe Greff:]

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

[Thomas Matthews:]

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

[Joe Greff:]

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

[Thomas Matthews:]

Obviously the goal of SB is for us to figure out incremental applications, change the way that we sell game content into the marketplace, and so there could be a little pickup in turns of kind of the run rates. But we really haven’t anticipated much. If you take a look at non-box revenues, they’re split about one-third, one-third, one-third to intellectual-property systems and conversions, conversions and parts. And so it’s really only that last category that’s a bit at risk as people stop supporting the older platforms and move to these newer platforms. But our systems business we expect is going to continue to grow and we think there is some real opportunities for us to continue to grow our IP business. I think in total we anticipate that that is still a growing line item.

[Joe Greff:]

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

[Thomas Matthews:]

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

[Joe Greff:]

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

[Thomas Matthews:]

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

[Operator:]

Your next question comes from Steve Wieczynski - Stifel Nicolaus.

[Steve Wieczynski:]

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

[Patrick Cavanaugh:]

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

[Steve Wieczynski:]

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

[Thomas Matthews:]

Well the deal for SB, I think, as we remarked in the past, in some respects remains to be determined, but the underlying business relationship of providing Advantage and other systems products remains the same. The idea is that we sell boxes in this case the AVP platform, all in the new cabinets with those LCD top boxes, is a one-time sale of hardware. We’ll start having an opportunity to package game content both with the initial sale of boxes but subsequently delivered on a floor-wide basis across the floor. That’s probably going to be a one-time charge based on number of seats that the product is made available to. We’re going to try to introduce new applications and those applications will have probably some upfront charges as well as some recurring revenue charges for supporting those applications, keeping them fresh, ongoing development in the matter. We’re going to have some IP charges, especially as it relates to certain of our technologies being made available to other vendors as they try to bring product to the casino floor. So all of those elements are at play here. We have, as you would imagine, some incentives given to early adopters, and certainly the MGM organization as a whole and CityCenter here specifically have really been terrific in that they have oftentimes been early adopters of the technology that we’re trying to bring to the industry. We very much appreciate that partnership. But I don’t think that the deviation is so great that the elements that we’ve previously identified, those kind of six categories or so of areas that we might be deriving revenues as we deploy SB, I think are all intact here and all present opportunities as it relates to the CityCenter deal.

[Steve Wieczynski:]

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

[Thomas Matthews:]

I sure hope so. I mean, that’s our job here is to go and try to figure out ways that we can expand our customer opportunities. We’re not much for making press releases, as you know, as it relates to securing new business because we think that is something that we do in the ordinary course. So every systems deal we get we don’t announce and every time we get a machine order we don’t make any particular celebratory noise about it; that’s what we do. In the case of SB, I think that these early adopters of Harrah’s and MGM are very important to make known. I think there’s probably a couple more that we’re working on, especially within our existing customer base for Advantage that are obvious efforts for us to deploy SB. I think if we make meaningful progress there we’ll probably go ahead and make sure that we let the market know. But over time we expect to be selling an awful lot of SB systems and probably not announcing every one.

[Steve Wieczynski:]

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

[Thomas Matthews:]

It has been and unfortunately I think that it’s mostly been a product of me in that I’ve been particularly picky on behalf of IGT. I think that we really want to make sure that when you get a person into that position that they can immediately help us with our global expansion, the transactional activity that we’ve got going on, on an ongoing basis, help us address capital deployment and including capital structure items; and, that they’re the right personality fit for this organization in a way in which they can represent us to a variety of external communities. So being that particular has meant that we’ve gone down the path here and there with a couple of different folks but have yet to really figure out just that right fit. It’s an ongoing effort and unfortunately at this point I would say with no imminent announcements.

[Operator:]

Our next question comes from Celeste Brown - Morgan Stanley.

[Celeste Brown:]

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

[Thomas Matthews:]

Well, what we said is that we think that there’s still, I believe mentioned on the last call, additional opportunity for us to exceed the range in one or both of the quarters in the back half of ’08 simply because we do have such good visibility to machine demand. The thing that could get in the way of that is deferrals, that purchase activity, either due to our inability to get approvals or due to either projects being delayed and/or customers just deferring decisions to future periods. So there’s certainly some risk to that visibility. There’s a natural uptick that we expect in game ops due to the seasonality. These next six months are the best six months of the year for game play levels. We think international kind of rebounds to more normalized levels and so there’s reasons for us to feel good about that range, including maybe being on the high end or exceeding the range for the next couple of quarters. You see us go back into ‘09 in a way in which we’re back to this kind of first half of the year where there’s seasonal impacts. There’s still us being somewhat dependent on new properties which we don’t control, and replacement demand still weighing a little bit in anticipation of truly new technologies being deployed. Going into that second half of ‘09, however, you can identify a lot of new and expansion opportunities for us to sell product. By then we expect that we really are starting to stimulate replacement sales here at IGT in advance of active SB decisions being made by our customers. So we don’t have any guidance yet for the back half of ‘09, but feel very good that there’s a real opportunity for that to be the strength of that fiscal year.

[Celeste Brown:]

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

[Thomas Matthews:]

No, it’s not, not on the personnel side. I mean the challenge, of course, is that we are developing a very broad system from scratch, and so just maintaining proper product definition and meeting those internal timelines is really the challenge. Of course along the way we’ve changed specifications somewhat of the underlying technologies. We have redefined some of the applications that we have as priorities, and still are working with customers to make sure that we kind of meet their initial requirements for the product. So there’s some movement of parts as far as that is concerned but I think we feel comfortable that we have the resources necessary for timely delivery. 4.0 is due right around that CityCenter opening and so where we are hoping that it’s deployed, it is 3.2, as we previously said that we for sure will have deployed in that property. If everything goes well, we have perhaps 4.0 in advance of that opening or maybe shortly thereafter.

[Celeste Brown:]

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

[Thomas Matthews:]

We had the opportunity for us to secure some gaming approvals and customer acceptance of really what people have originally defined server-based gaming as in the way of download gaming config. We wanted to go ahead and get that done, have the proof of the technology that we could have this broadband delivery of various applications. As you know, in our minds what distinguishes this product from previous interaction with the player is that we’ve moved the customer interface to the primary game screen and so deploying the SB Window is also in our minds extraordinarily important to core functionality. That’s why it’s still in that generation 3 effort. 3.1 and 3.2 are just perfection of delivering that SB Window. So that’s the reason it’s being phased is just for us to secure timely gaming approvals.

[Operator:]

Our next question comes from Bill Lerner - Deutsche Bank.

[Bill Lerner:]

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

[Thomas Matthews:]

Sure. If you take a look at SG&A, with all the noise removed of both last quarter’s hurricane proceeds and the sale of aircraft and this quarter’s one-time item items associated with a few internal decisions relative to the economic environment in which we’re operating, the SG&A year over year is actually reasonably flat to comparable figures. R&D is up, and depreciation is up because of the growth in the install base. And so there is some growth in operating expenses in total. But hopefully that reflects either previous growth or ambition for growing the company prospectively. SG&A needs to be sized right. I mean, all operating expenses need to be sized right relative to the overall size of the business so that we have goals, as you know, of bringing at least 30% of our overall revenues to the operating income line. We’ve been historically able to do that by realizing margins let’s say in the neighborhood of 50% to 55%, and then the rest of that is captured within operating expenses. So we forecast operating expenses at 26% to 28% in the back half of the year. I think that that’s probably a good run rate for us going to ‘09. But if for any reason we ever felt like revenues weren’t going to trend up to properly support these expense levels, we would go back and revisit our spending and cut if necessary.

[Bill Lerner:]

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

[Thomas Matthews:]

I think that the biggest thing that people really believe in is that SB Window, the idea that we’re going to have a much better customer interface than we’ve ever had in times past. We’ve talked about this a little bit, and that if you take a look at the original player tracking systems, up until just seven years ago, those were two-line dot matrix displays for messages to the player. NexGen was revolutionary in that we had the ability to articulate a much more robust message, and as a result support bonusing. The bonusing that’s really made a difference of course is Lucky Coin, which is branded differently at a couple of different places but the idea that you have a floor-wide mystery jackpot, and Extra Credit, which is the idea that you automate some of the player tracking comp conversion to play activity at the machine. The idea that you can expand on that and have things like tournaments or a more robust Lucky Coin promotion. It’s better articulated to the player, or the player can access their activity more readily through the SB Window as opposed to some form of lookup window that we can direct-market various customer messages to them to try to impact their overall behavior across the floor. I mean a place like CityCenter, for instance, as you know really only anticipates maybe 40% or even less of their overall revenues being driven on the gaming floor. So they’re trying to anticipate ways that they can drive revenues while they have a captive audience by getting messages to the players at the gaming devices. SB Window I think has really been the decisive rationale for Harrah’s and MGM to go ahead and make the SB commitment. But in the case of MGM and CityCenter, it’s also an expansion of what has been a long-standing system relationship and so for them, we’ve really appreciated the support that they’re big believers in Advantage and the things that we’ve already done with floor-wide efforts, and they just see us continuing to be able to offer more under this new delivery mechanism.

[Bill Lerner:]

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

[Thomas Matthews:]

I think that there was some headline risk to today’s press release in that people who aren’t necessarily trying to be long-term investors might make decisions based on the first couple of sentences in the press release. I think that folks that have made long-term commitments obviously are following the progress that we are making on delivering SB and being able to assimilate replacements, being able to follow the ongoing growth of our game ops installed base, and the reliability of that business. Although play level is somewhat affected by economic factors this last quarter the fact is still an upward trend is alive and well there. Non-box sales demonstrate diversity away from this core need to ship boxes. I think all those things that have made us an interesting company for long-term investors very much remain intact. The fact that we can be on a call and remark on visibility to a much improved environment for the back half of ‘08 and reasons to share optimism about ‘09 and really know that SB will be delivered and impacting our 2010, none of those things have changed. So the day-to-day changes in the overall valuation of the company don’t always make sense in terms of really reflecting what is, I think to people that are close to our efforts, the underlying strategies.

[Operator:]

Our next question comes from Robin Farley - UBS.

[Robin Farley:]

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

[Patrick Cavanaugh:]

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

[Robin Farley:]

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

[Patrick Cavanaugh:]

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

[Operator:]

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

[Amir Markowitz:]

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

[Patrick Cavanaugh:]

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

[Amir Markowitz:]

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

[Thomas Matthews:]

I think that’s the goal that we have is that we can demonstrate into new properties on a discrete basis on a couple of trial floors in advance of that the opportunity for us to really grow revenues as well as maybe help capture some managed expenses. So if we can do those things, then we think that we’ll have a compelling ROI presentation for us to be able to present to our customers a rationale for them replacing or upgrading existing floors. If you take a look at the trial location that we have for 3.0, it is another of the MGM properties and so that does demonstrate that corporate-wide they’ve been big supporters of these efforts. Well, given that was the last question of the call, I very much appreciate everybody’s attention this morning and look forward to remarking on what will be a much better quarter on our next conference call. Thank you.