Brightstar Lottery PLC (BRSL) 2004 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the IGT second-quarter earnings release conference call. (OPERATOR INSTRUCTIONS). I would now like to turn our conference over to our host, Rich Baldwin, Director of Investor Relations. Please go ahead, sir.

Good morning, everybody, and thank you for joining us today. Also on the call today from IGT is Tom Baker, our Chairman, T.J. Matthews, our CEO and Maureen Mullarkey, our CFO. Before we begin, I would like to note that during the quarterly earnings conference call, certain statements will contain forward-looking information such as forecasts of financial information. Although IGT believes that the expectations reflected in any of its forward-looking statements are reasonable, actual results could differ materially from those projected or assumed. IGT's future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent known and unknown risks and uncertainties. IGT does not intend and undertakes no obligation to update our forward-looking statements to reflect future events or circumstances. All forward-looking statements in this conference call reflect IGT's current analysis of existing trends and information and represent IGT's judgment only as of today. Actual results may differ from current expectations based on a number of factors affecting IGT's businesses. Information on factors that could affect IGT's future business and financial results are included in our annual report on Form 10-K for the year ended September 30, 2003 and other public filings made with the Securities and Exchange Commission. This call, the Webcast of this call and its replay are the property of IGT. It is not for rebroadcast or use by any other party without the prior written consent of IGT. If you do not agree with these terms, please disconnect now. By remaining on the line, you agree to be bound by these terms. With that, I will now turn the call over to our CFO, Maureen Mullarkey.

Thanks, Rich. I am happy to report that the second quarter of fiscal '04 marks the 17th consecutive quarter in which our earnings have increased over the prior comparable year period. During the current quarter, both income and diluted EPS from continuing ops improved 32 percent and 23 percent, respectively, over the same quarter last year. This primarily resulted from record quarterly domestic replacement sales volume, strong international machine sales volume and significant gross margin expansion within our product sales segment. Note that as we mentioned in our press release, our current-quarter operating results included a loss on early retirement of debt of 4.3 million, which was net of tax, or 1 cent per fully diluted share. SG&A expenses also increased during the quarter related to charitable donations of 3.2 million net of tax or 1 cent per fully diluted share. During the quarter, we donated $5 million to the University of Nevada, Reno; we matched the donation of our Chairman Emeritus, so together we donated to the University $10 million for their new learning center. We were very excited to help the University achieve this very important milestone. Once again, our record earnings reflect the commitment made to our customers to be the leading provider of gaming machines, the leading provider of platforms and systems. During the quarter, we generated record topline revenues of 636 million, representing a 20 percent increase over the prior year.

Notable operational achievements in the current quarter include consolidated product margins of 53 percent versus 48 percent in the prior year, an installed base of 35,500 recurring games. That's up over 2700 from last year. We deployed IGT charitable recurring revenue games in Alabama, which is a brand-new market. We deployed IGT video lottery recurring games in New York racetracks, also a new market. We extended our contract with Sony Pictures through calendar 2014; that is related to our Wheel of Fortune mark. And we also extended our Price is Right mark during the quarter as well. We deployed two new platforms during the second quarter. One, the Wheel of Fortune Special Edition on our new AVP platform, and we also introduced our Real Touch series. Real Touch will be introduced both in Class II Native American markets and in traditional casino markets.

Moving on to my financial update, product sales highlights, revenue during the quarter totaled 362 million. That's an increase of 42 percent over last year, primarily related to strong replacement demand for our products, driven again by the overwhelming acceptance of our ticket-in, ticket-out technology and our leading game design efforts. During the first half of the year, I'm happy to report that we introduced over 70 new themes into our markets. That's comprised of 32 for sale products, 30 wide-area progressive products and 11 Class II Native American themes. Let's see, total quarterly shipments at 45,400 were comprised of 27,200 domestic shipments and 18,200 international shipments. Consolidated average selling prices were 8,000 for the quarter; that's an increase of 9 percent over the 7300 in the prior-year quarter and an 11 percent sequential increase from the 7200 in the December quarter. The increase in consolidated average prices was driven by really several factors, including a greater mix of intellectual property-related revenue, mostly related to our ticket-in, ticket-out technology, a greater mix of systems-related revenues resulting from the Acres acquisition and favorable foreign currency exchange rates. Domestic shipments comprised 60 percent of the total in the current quarter compared to 57 percent last year. Domestic ASPs totaled 10,100 for the quarter, an increase of 9700 in the prior-year period and a decrease from 10,500 in the sequential quarter. Both the year-over-year and sequential ASPs were aided by stronger pricing realization and greater systems-related revenue. However, record sales volumes in the current quarter did result in slightly higher machine discounts.

International ASPs were 4800 for the quarter; that was up from 4200 in the prior year and 4,000 in the sequential quarter. That was due primarily to a greater percentage of sales in the European casino markets and favorable foreign currency exchange rates. Product sales gross profit margins in the quarter totaled 53 percent versus 48 percent in the prior year, due primarily to improved operating efficiencies related to high production volumes, as well as the increase in domestic ASPs mentioned above. During the quarter, we produced 33,500 machines at our Reno manufacturing facilities versus 18,800 in the prior year, remembering that the March quarter was our start-up quarter for our new ERP system. And we also produced 34,600 in the December quarter or the first quarter of '04. Looking forward, due to a conservative view on the geographical mix of product sales, the contribution related to higher EZ Pay-related systems, the Acre acquisition, international parts and what looks to be lower FX rates, we expect the full fiscal year gross profit margin to trend around 51 percent.

Domestic product sales totaled a record 27,200 units comprised of replacement sales at 86 percent of the total. Domestic replacement sales totaled 23,400, primarily from strong sales across all of our domestic markets. This was offset by fewer replacement sales into Canada; we had large sales into the Quebec and Saskatchewan markets of last year. Large replacement shipments for the quarter included over 7800 units to the Harris properties across several different jurisdictions; that represented an aggregate market share of 82 percent; and we shipped 2300 games to Stations properties for an 89 percent aggregate share. Given our strong replacement sales performance for the quarter and the year, we are raising our domestic replacement sales target to 65 to 70,000 machines for fiscal '04. This is up from the previously communicated target of 60 to 65,000 machines. By the end of fiscal '04, we estimate that the size of the remaining domestic replacement market or the eligible targets for replacements to range from 200 to 250,000 machines. That said, we expect the domestic replacement market to be strong over the next couple of years.

New and expansion units totaled 3900 machines during the quarter and were concentrated primarily in Native American markets. The largest sale during the quarter was to the Seneca Allegheny property for 1,000 units or a 66 percent market share. Note that just this morning, we announced an agreement with Stations Casino, and with Stations Casino has agreed to buy 2100 gaming machines from IGT, representing an 80 percent market share for its new Redrock station, scheduled to open in either late '05 or early '06.

Turning to our Gaming Systems business, our EZ Pay ticket-in, ticket-out system continues to be one of the primary drivers of domestic replacement sales. At the end of the quarter, there were over 150 keno systems in operation. In looking at total Gaming Systems, which is now inclusive of Acres, we now have 235 Systems customers. And at the end of the quarter, these systems were communicating with approximately 218,000 machines. At these levels, we now have become the premiere provider of Gaming Systems offering within the worldwide gaming market. In addition to the Stations announcement this morning, we also announced the award of our advanced patron loyalty system by Wynn Las Vegas Hotel and Casino, which is slated to open in the spring of 2005. The Wynn Las Vegas property will showcase the latest in Acres' advantage suite of products, including Acres’ bonusing and Next Gen interactive media displays, together with IGT's Table Touch Gaming Management System and the EZ Pay IDS cashless gaming system. We're very excited about both of these announcements this morning.

The other primary driver of our domestic replacement demand, as always, continues to be our extensive game library across our Spinning Reel, Video Spinning Reel and Video Poker products. Our top-selling Video Spinning Reel game themes included, during the quarter, Hexbreaker, Wild Taxi, Cops N' Donuts, Ghost Island, Kenny Rogers and Phone Tag. Our top-selling Spinning Reel themes for the quarter included Triple Double Wild Cherry, Triple Stars and Triple Double Stars.

International product shipments totaled 18,200 during the current quarter, an increase from 15,000 in the prior year, due primarily to strong sales in Japan driven by our popular pachisuro game, Nobunaga, which has become our highest-selling game ever in the Japanese market. We also achieved strong volumes in the European casino market, including 430 units into Russia, offset by fewer AWP sales from our Barcrest subsidiary. In total, our international division achieved solid results during the quarter, with total revenues and operating income posting year-over-year growth of 40 percent and 69 percent, respectively. In addition, during the quarter, we also entered into a partnership with one of the most successful manufacturers in the Japanese pachisuro market, Sammy Corporation. This should enable IGT Japan to substantially improve its product offerings and market acceptance into the future. Note that we do not expect to sell any units in Japan under the Sammy partnership until fiscal '05.

Moving on to our second business segment, Game Operations -- Game Operations revenue for the quarter totaled 274 million, which is a slight decrease or $800,000 from Q2 of last year. The decrease in revenues is primarily related to the revenue impact in the prior-year results, due to the record Nevada Megabucks jackpot of $40 million that hit in late March 2003. In addition, we had some calendarization differences year-over-year. For example, the New Year's Eve holiday this year occurred in our first quarter and last year, it occurred in our second quarter. During the -- excluding the Megabucks effect in Nevada and the New Year's effect across all jurisdictions, our second quarter wide-area progressive play levels increased across the majority of the domestic gaming markets. Quarterly gross margins were 54 percent, flat compared to last year. We continue to improve upon our mix towards the wide-area progressive games and instant-winner games as well as on our brand extension strategy.

The installed base of IGT-owned recurring revenue games, which is comprised of machines operated in both casinos and rasinos, ended the quarter at a record 35,500 machines. That represents an increase of 2700 machines over last year and 1100 games sequentially. Going forward, we will be using a new metric in describing the installed base of recurring revenue games. We will collapse what we now call rasino games into the casino category and describe this as IGT-owned games. We will also continue to comment on casino-owned games, which include our Action Gaming Poker and premium products. Of course, we will always describe and share with you the elements that do impact revenue, margins and yield. And we will do that on a jurisdictional basis as well as on a venue-based method. Year-over-year growth of 900 games in the casino market category primarily resulted from increased placements across various Native American markets, as well as our first placement of charitable video bingo games in Alabama during the quarter. In addition, our continued managed removal of end of life former anchor stand-alone units resulted in 400 less units when compared to last year. On a year-over-year basis, our wide-area progressive games are up 1100 machines and our Native American machines are up 800 as compared to last year. The casino market major contributors that are mentioned include Alabama -- we placed 300 machines at the Victory Land Racetrack. Recent popular games include TV hits inclusive of Beverly Hillbillies and M*A*S*H; placements of perennial favorites -- Wheel of Fortune Spinning Reel and Wheel of Fortune Video were strong during the quarter. And also very importantly, we introduced Wheel of Fortune Special Edition on our new AVP platform. This was introduced late in the quarter, with initial customer acceptance being very, very strong. New game introductions planned for next quarter include Animal House, Gilligan's Island and Monty Python.

Year-over-year growth of 1800 games in the rasino category resulted from increased placements in Rhode Island and Delaware, where we continue to improve our game performance in these markets, increasing our market share, as well as machine placements in New York related to the commencement of video lottery operations at three racetracks within the state. We currently have installed 800 machines in the New York market, 700 machines in the Rhode Island market and 300 games in Delaware. I am sorry, these are the increases over the prior year -– a 700-machine increase in Rhode Island and a 300-machine increase in Delaware.

On operating expenses for the quarter, they totaled 133 million versus 110 million in the prior year. SG&A expenses for the quarter totaled 80 million; that's an increase from 71 million in the prior year. R&D expenses for the quarter totaled 31 million, up from 23 million last year. The increases in both SG&A and R&D are due primarily to increased headcount resulting from the Acres acquisition as well as additional employee-related costs, including performance-based incentives and health-care benefits. Also included in SG&A was the aforementioned charitable donation of $5 million.

G&A expense for the quarter totaled 16.7 million versus 11.5 million in the prior year, again, primarily related to the Acres acquisition and amortization of lived intangibles. Bad debt expense increased to 5.7 million in the quarter versus 4 million in the same quarter last year, due primarily to higher sales volume. As a percentage of total revenues, operating expenses totaled 21 percent, in line with the prior year. Operating income for the quarter totaled a record 206 million or 32 percent of total revenues as compared to 160 million in the previous year or 30 percent of revenues.

Moving on to cash flow and the balance sheet, for the year, we generated 165 million of cash from operations on income from continuing ops of approximately 234 million. After funding various investing and financing activities, our cash balances decreased 300 million to 1 billion at the end of the quarter. Days sales outstanding were 87 during the quarter compared to 108 days in the prior-year quarter and 96 days in the sequential quarter. I'm happy to report on the improvement in days sales outstanding and most of that was related to the payoff of the Pollow (ph) loan of $51 million during the quarter.

Inventory turns improved to 4.1 times during the quarter compared to 3.3 times in the prior year and 3.4 times in the sequential quarter, primarily due to record sales volume during the quarter. We also saw lower finished goods inventory at the end of March as compared to December, mostly related to shipments to the Harris properties across many markets.

Capital expenditures in the quarter totaled 93.3 million; that included approximately 9 million into Class II markets, 6 million into public gaming markets, 51 million into casino markets. We also invested 12 million in intellectual property, mostly related to the Shuffle Master transaction and 15 million in property, plant and equipment.

In the financing category, we paid cash dividends of approximately 104 million. We also repaid 400 million of our debt. These investing and financing cash usages were partially offset by cash proceeds received from the sale of OES of approximately 143 million during the quarter. In total, we are very pleased with the significant cash generation achieved during the fiscal '04 period.

Before I turn over the call to T.J., I would like to conclude my remarks with earnings guidance. At this time, we're happy to report that we are comfortable with the mean street estimate of $1.31 for the full fiscal 2004 period. As a reminder of information previously communicated, latter half volumes domestically will trend lower than the first half due to record shipments to multi-jurisdictional customers. Also based on the information currently available, we expect shipments during the third quarter to trend just slightly lower than the fourth quarter, again related to record volumes to multi-jurisdictional customers in the second quarter. That concludes my prepared remarks on the financial update. I'll now turn the call over to T.J. Matthews.

Obviously, we want to thank everyone for joining us this morning. And we certainly like the idea of being able to share yet again another record quarter and its results with you.

Before we talk about the questions that you might have, I thought that we should talk about market development since that's so important to our continued growth here at IGT. And although we have been disappointed recently in Maryland, we've had several surprises with new legislation and have reason to remain optimistic in additional states, including Kansas and Maine and Michigan, Minnesota, Nebraska, Pennsylvania and Texas. We also obviously believe that the ongoing compact negotiations in California have been at a critical juncture here for a couple of months and that we continue to remain very optimistic about the outcome of expanded gaming there, as well.

Moving back over the past few months, we did experience some great progress in market development. Legislation was passed in Oklahoma, the Bill 553, which outlined the terms for Indian gaming compacts and for the legalization of similar gaming machines for three racetracks in the state. In addition, a referendum was passed in certain parts of Alabama last November that allowed for video-based charity games. As a result, we were able to leverage off of our internal Central Determination System efforts and capitalize on this opportunity in Alabama as we've discussed with you. We installed 300 of our IGT Real Touch Bingo gaming machines and the requisite Central Determination System. And we have been operating successfully at the Victory Land Greyhound Track in Alabama since April 1. This internal development of an entirely new gaming machine platform and system has been a huge undertaking for IGT since we dedicated ourselves to the effort about two years ago. And since we go live on April 1, we believe that our technology has proven itself to not only be feasible but also to have game performance exceed our initial expectations.

Going forward, the Alabama Senate has already approved a ballot measure that will legalize charitable gaming for the two remaining racetracks in the state. We remain optimistic about this opportunity as well, as those two tracks are located near the state's most populous city.

Also subsequent to our last conference call, the U.S. Supreme Court denied the Department of Justice's appeal of both lower court cases, which effectively legalized Class II Native American gaming. For the past several months, we've been actively marketing our Class II products at several industry trade shows and customer feedback has been very good. At the current time, our Class II products have been submitted to the NIGC to seek a Game Classification advisory opinion and to the GOI for testing and certification purposes. With that, we remain on track with our previously communicated plan, such that we will be operating in Class II markets in fiscal 2005.

I would also like to tell you about our activities with the New York State Video Lottery. We shipped our first 316 (ph) units in January to the Saratoga facility; and by the end of the quarter, we've installed now 783 machines in the three tracks that are up and running. Given our game performance to date, which we believe is leading the market, we would expect that our market share will increase over time as the New York Lottery commences the reevaluation period. We anticipate that this will occur in about six months from the commencement of operations at each facility. And as we mentioned on our last call, although it's been a long time in the making, we are very excited about the New York opportunity because as of today, it remains the largest new market opportunity for us here in 2004.

I also would like to tell you about what happened in the United Kingdom. In early April, the Parliamentary Joint Scrutiny Committee on the draft Gambling Bill released its final report. And although the market is expressing concern about the proposed cap of 1,250 machines per resort, we remain very comfortable that our estimate of 40,000 machines in the United Kingdom within two to three years after legislation becoming effective is something that is going to occur and could occur as early as 2005.

Again, I want to thank you, very much, for joining us today and want to answer the questions that you have now.

(OPERATOR INSTRUCTIONS). George Smith, Davenport.

You may have mentioned this and I apologize if you did, but the R&D figure we saw in the quarter bumped up a good bit. Is that a good run rate going forward?

I think it is a good run rate going forward. And the increase is primarily related to the inclusion of Acres Gaming, and also the headcount additions related to our investment -- across all -- everything we do, platform, games. But we have increased our investments in the R&D related to Systems product, overall.

And New York -- T.J. just mentioned the fact that your games seem to be performing well. Do you have any numbers that can put that in perspective, give us a feel for how you are doing relative to the other market participants.

As I said, I think we have reason to believe that we are -- that our machines are the leading win-per-unit machines installed in that marketplace. But the figures have been kept confidential by the State Lottery.

When will they re-allocate share?

We expect that every six months from the initiation of operations within an individual operation and then six-month intervals thereafter.

Okay. Thanks a lot.

Steve Kent, Goldman Sachs.

Just a quick question on your participation games. It just, you know, looks like the installed base sequentially just is decelerating a little bit in the traditional markets. And also the same-store sales were a little bit light. Could you just talk about if you have any new products coming in that you think begin to reverse that in the next couple of quarters? Are you seeing competition out there heating up, especially from Aristocrat? Or is it some cannibalization?

Well, as we described, there were some issues relative to year-over-year comparisons exclusive to the quarter, and so we would really suggest that people look at year-to-date comparisons, where we can say that the gross margin is up 8 percent -- a very good figure in comparison to the growth of the overall industry. We think that being plus 2700 units for the year and 1100 units for the quarter is also indicative of the fact that new products are being introduced into, in some cases, new markets, but in most cases, into existing markets, and I'm having more and more success expanding our footprint.

The new products that I think really that we're most excited about is the platform of AVP -- that there is no doubt that the videogame sector of the industry is by far and away the most competitive segment, that companies like Aristocrat and WMet (ph) being more focused within their own operation certainly represent kind of a renewed competitive vigor out in the marketplace for us to be cognizant of. We nonetheless feel very comfortable that our platforms are the best, that our games are the best, and that we are the easiest decision for some casino to make in terms of deploying new games on their casino floor.

And so I think that there being no one product for us to identify, although we talked about the Wheel of Fortune Special Edition as being something exciting, probably the key factor for you, Steve, is the idea that we put 30 new games into the gaming ops segment this last quarter, 11 new games in the Central Determination, or year-to-date so far in both those instances; and that kind of prolific output is going to continue at IGT.

Hey, T.J., any just quick comments on low-denomination games? Are you continuing to see strength there?

That's a huge trend. And more and more, you're seeing bigger percentages of the floor. I think your survey did a good job of identifying that as an ongoing trend. We are over 30 percent in many of our major casino markets for the installation of penny and nickel games. I think that continues to happen. That's a phenomenon of video and that's a phenomenon that results from the implementation of ticket-in, ticket-out, which as you know has been primarily driven by IGT.

Robin Farley, UBS.

I have three questions. One is, I want to make sure I'm looking correctly at the installed base of the gaming operations in casino markets. The games that went live April 1 in Alabama, you are counting those as at the end of the March quarter. And I just want to -- if we looked at Alabama as a Central Determination market and just looked at casino markets, it looks like there was a sequential decline of about 300 units. And I just want to make sure I'm doing the numbers right on that.

And then also I wonder if you can address, it looks like there was also a sequential decline in the revenue growth profit per unit from the revenue sharing games in casino markets. And I understand the year-over-year comparison being affected by the Jackpot. But I wonder if you could talk about the sequential decline?

In Alabama, we commenced operations in the -- at the end of March; it was an official go-live date of April 1; but we were up and running before the end of our quarter. We did see a sequential decline in the Mega Jackpots. We did comment that we did remove some of the end-of-life games.

Regarding the yields on gross profits, I think the sequential decline, you have to remember two things. And we did have some interesting calendarization issues this year. We had an extra week last week -- or last quarter. And also in the December quarter is when we recorded the New Year's Eve holiday. So there was -- it does look to be a sequential decline, but from a year-to-date basis, as compared to last year, as T.J. mentioned, gross profit dollars are up 8 percent. So I think that's a better metric to look at because of the calendarization issues. And I think you had one other question.

Yes, well the question is -- I think was answered about Alabama and the installed base. And you answered the question about recurring revenue. I would just tell you, Robin, that when we do the adjustment ourselves for the extra week for year-to-date comparisons, calendarization, other things that we know within our own operation, that we feel very good about the trend in Mega Jackpots. We think that our move of 1100 machines into the wide area progressive pricing, our move out of -- you know, from a percentage basis, more and more so into Native American casino environments, that generally speaking have higher wins per unit -- portends very well to good trends prospectively in revenue per unit, gross margins per unit and overall revenue in that segment.

If you look at the gross profit per unit per day, would that be enough in your view to take into account that there was an extra week?

Well, it's not -- the one week won't get you all of the 8 percent. But certainly, you cannot ignore the fact that we did have one extra week this year in comparison to last year.

Some of the -- what you should remember too on the gross profit per day, we do have some ramp-up costs this year as well, related to the ramp-up in New York and related to the charitable market of Alabama. So that did suppress some of the gross profit per day, slightly. But those are dollars well spent.

Okay, great. And then the last question is, on the product sales revenue, can you talk about selling price per unit when you take the revenues and divide by the number of units? I guess I wonder if you could give us some sense of the Systems-related revenues, just so we could look at what the product sales -- what the unit revenues are divided by number of units, rather than adding the Systems revenue in and dividing that over the number of units as well?

Let's see, I don't have that readily available. Let's see here. Okay. We had -- from an average perspective year-over-year, we saw -- average price on machines -- this is for the quarter year-over-year -- up slightly and we did see an increase in the Gaming Systems related to the inclusion of Acres Gaming, and parts and other. I would say that the machines were about 8100 and then the rest was comprised of gaming machine parts and other, to get to 10.1. So most of the increase was related to the other elements of product sales. But we did see a nice increase in the gaming machines, as well.

If you back out the Systems revenue from both periods, what would the percent increase look like in the --?

It's comparable, Robin. We don't break out the different levels of the average pricing, you know. Our systems are onetime sales. Our IT-related is onetime and our parts. Some of these -- what's happening is, I think that Acres together with IGT on a 12-month run-rate basis, will probably have somewhere about $100 million in revenue. And you compare that to total game op -- or total product sales revenue and it's really not over 10 percent. And it's good, it's great. It's higher than we ever have had. It's leading in the market in the industry. But that 10 to 15 percent is sort of my threshold where we split it out and comment on it. Other than that, we will blend it with overall product sales.

And then on the IT side, the trends, to give you some verbiage on the trends, as our customers across the market hook up their machines to ticket-in, ticket-out systems, there is a onetime fee. And we are starting to see an increase. Those trends are not always consistent, but I would say in general, they are up -- well, they're definitely up on a year-over-year basis, but they do fluctuate some from quarter to quarter. Those are very high-margin revenue dollars.

Great. Thanks, very much.

Bill Lerner, Prudential.

Just a couple questions, one just on the balance sheet. I saw long-term notes payable or your debt number up marginally but you took 400 million out. Can you just talk about how that -- what am I missing there? And then just a follow-up, can you quantify a little more what appear to be big opportunities that are not getting a lot of airtime. Well, Japan you are talking about but not quantifying as much -- as well as Italy and Poland. Thanks.

On a year-over-year basis, as far as long-term notes payable, that's really the convert. We did pay off early by three months, the 400 million tranche that was due in May. We paid it off in February. I think that's the gist of the balance-sheet question.

But you mean you've effectively seen debt come -- so now the convert's in the share base, effectively, right, so you've seen debt come up --?

But the -- the accounting for the convert -– you’re right, on the P&L, we do use the if-converted method. We have provided a table in the press release on how to get to that number. But the accounting also says that the debt stays on the balance sheet.

Understood, okay. And then just on the international.

This is Tom Baker. I will comment a little bit on that. In terms of Japan, we are happy with what's been happening in Japan organizationally and what we've been doing this year. Granted, we have had a good gain. And the Japan market tends to trend on a quarter-to-quarter basis or year-to-year basis, certainly on the number of good games that you have and there's not very many introduced each year, generally only about four and sometimes only three and maybe as many as five. But we're having a good year now. We have some building plans organizationally and then our relationship with Sammy we think is going to be a positive thing for us overall in the Japanese market. And we are very comfortable with the Sammy relationship and how that will unfold outside Japan -- are things we'll just have to talk about in the future. We are not sure at this point.

As far as Italy and Poland, yes, we're aware of those. We do not talk about them too much. That does not mean that we're not on top of them and very closely. But I just don't think there's much to say right now about something like that. They are huge opportunities. Huge opportunities come and go. And so we generally don't comment on those too much until they materialize to a point that we can quantify them a little better.

Got you. Thanks, guys.

Harry Curtis, J.P. Morgan.

A couple of quick questions, please. First if you could give a little bit more color on game ops. The decline in the margin sequentially was from about 57 percent to 54, and I would like to have a little bit more color on why that occurred and what we should expect over the subsequent quarters. And then second question is, you mentioned the probable number of replacement units left to go at 200 to 250,000. I am wondering if you are backing out those units that are unlikely to ever replace to get to that number?

On the margin sequentially, Harry -- the game ops-related margin -- down related to interest rates. We did see a decline in rates quarter-to-quarter. And that is part of the business. And I would say slightly higher expenses -- most of it was interest rates -- but slightly higher expenses related to -- versus the revenue -- if you will, from New York and Alabama.

Would you expect that -- is it not the case that your mix is shifting given New York and Alabama and that we should expect a lower margin going forward? Maybe that's the bottom-line question I'm after.

I don't think it's going to be a discernible difference in margins going forward. I think we're going to be around -- I think we've talked about 54, 55 percent. And I think that --

I think margins stay static. I think what might change, Harry, with the shift to the rasino markets is revenue per unit and gross margin per unit -- might decline over time if that mix shifts too much. But we have not gotten to the point of necessarily guiding people accordingly yet. I mean, the goal is to continue to maximize both in both segments of our IGT-owned area.

As far as kind of that identification of the 200 to 250 units, yes, you are right. We have eliminated some units that we think are unlikely for replacement in terms of our target. That includes -- which is not necessarily always identified in some of the analysis that we see -- that includes the machines that we own that we have out in the marketplace which are in fact going to be upgraded or have been upgraded to ticket-in, ticket-out but are not candidates for us to count in terms of our games sold (ph) efforts. And so that is really kind of the quantifiable, immediate targets for us to go out and upgrade the ticket-in, ticket-out technology.

So a follow-up question then, if you've got an installed base in North America of around 700 to 750,000 machines, about how many do you think are unlikely to ever replace?

Well, I think that's -- I think everybody is kind of guessing at that figure. As you know, we agree with the figures out there, that about half the market or approaching half the market has in fact, been upgraded. If you use the 740,000 figure and divide by two, that leaves you 370. And our range of product would say back out the 35 that we have and have probably about another 90 or so that don't seem as likely replacement candidates in the immediate future. But over time, certainly, all of the machines are likely to have ticket-in, ticket-out capability at some point.

Very good. Thank you.

David Anders, Merrill Lynch.

Two issues -- first, Maureen, do you have the power (ph) class unit sales number?

Yes, I do.

Could I get that please?

Sure. I think it was 8600. Let me get to that page. It was 8200 in the quarter. And for the year-to-date period, 14,700.

My second question is with respect to your forward guidance, does that include the $4.3 million hit in debt and $5 million -- so you're including that in your earnings calculations? Or are you excluding those and saying you could earn $1.31?

It is including it, isn't it? Yes.

So you're just -- okay.

We previously guided that, you know, we were going to have a penny less as a result of the Philly debt retirement this quarter, and be plus a penny next quarter as a result of interest rate savings.

Right, right. Okay. Thank you.

David Vas, Banc of America Securities.

I have a question, a couple questions. First of all, with respect to your Class II technology, if I'm not mistaken, it appears to be CD-ROM-based. How far are you towards moving towards a more downloadable platform? Or is it a priority at this point?

Well, I think that there is no doubt that system distribution of games is becoming more and more prevalent. And I would agree with you for right now, it is mostly centered around distributing game outcomes. In some instances, there's some discrete system distribution of code, but very rarely. I think if there is a Next Generation of gaming, it's going to be server-based in nature. That's going to allow for a different kind of game deployment; it's going to allow for some efficiencies to be realized, particularly in wide area environments. And I think that you're starting to see that discussed more and more in European marketplaces, particularly in Norway where they had an RFP for server-based gaming. With us, for us, we've -- I think we've commented that we think it's probably a three-to-five year activity for -- to be realized here in the United States, but that we have embarked upon a server-based gaming initiative at IGT and it remains under development.

Okay, great. A couple questions for Maureen. Can you talk about the product sale gross margins, domestic versus international?

Sure. The domestic product sales gross margins in both the domestic markets and the international markets posted increases. Year-over-year -- the international margins in Q2 were about 46 percent, a little bit less than 46 percent compared to 42 percent in the prior year. And that resulted from results out of IGT Europe with sales into the European casino markets. They did realize slightly -- a good mix, if you will, with higher margins. And then of course, foreign exchange rates. I think that a Euro is at about $1.25 -- or 125 when we ended the quarter. I think it's up 120 at this point. So it's an opposite trend than we experienced over the last year or so. But international margin is quite good and strong shipments across all markets.

Domestically, product margins were about 55 percent compared to 50 percent last year. That relates to operational efficiencies in the Reno plant. We are starting to see some benefits from our new ERP system. We are starting to see just general efficiencies. As I mentioned before with ASPs, we have a greater mix of intellectual property-related revenue for machines that are hooked up to our ticket-in, ticket-out systems. We now have the inclusion of Acres Gaming together with IGT Systems business; those margins trend at about 60 percent. And then we're starting to see some of the realization of the price increase from last year as well.

Okay. Last thing, briefly, on the cash-flow statement, it looked like the CFFO for the second quarter was light compared to the first quarter. I'm wondering if there is anything we should be thinking about there?

What was that metric?

The cash flow from operations, I think, for the year --?

Sure, okay. We -- very good results, very good results in working capital with improvements in days sales outstanding and inventory turns. Best metric ever that I've ever seen at IGT, and I've been here a long time. We did invest in some new marks, both with Columbia Tristar, Sony and with the Price Is Right. We're not able to disclose those amounts, but it did secure those marks for Sony related to the Wheel of Fortune and Jeopardy! and some other marks into the year 2014.

Steven Crow (ph), Monez (ph) Cresty (ph).

Yes, can you just expand a little further on the subject of the Class II gaming, where are you guys with that technology? Have you manufactured Class II machines? And kind of where do you see that market going with respect to your involvement? Thank you.

Well, as you know, I think we're waiting to see what happens with Class II markets on an individual basis. In the case of Oklahoma, it appears that it's going to change and be somewhere between a Class II and Class III environment. And so our product is going to need to accommodate as much. The Class II discussions for California seem as if they are going to be preempted for expanding Class III gaming. We are the market leader already in Washington from a both content and a box perspective with distribution through Sierra Design Group. The same can be said for us in Florida, where we have over 4,000 IGT boxes placed. So really, the market that is, I think, the best example of new markets for Central Determination and Class II-like devices is Alabama. And us having product in that marketplace, proving itself technologically, proving itself from a game-performance point of view is an incredibly important milestone for us to say that we have technology that puts us into charitable gaming, Class II gaming, Central Determination System kind of environments. And I think we share people's optimism that now that the rules for such have been clarified, that there's going to be new opportunities that are going to result from that. But we're now active in that space.

Great, thank you.

Jeff Martin, Roth Capital.

My question pertains to Class II as well. Could you explain a little bit of your experience to date in Alabama, how things are going and what are some of the challenges that you may have come across?

I think for us the challenges that we've come across are the normal challenges of new product deployment. And I don't think there have been any -- there certainly have been no negative surprises, but all the little tweaks that you want to address in terms of new systems and new platforms, we are in the process of addressing. And getting on to kind of the heavier lifting of making sure that we have the very best games. With 11, the library is not very big yet. So we need to increase that library and make sure that we have a good deployment of games out in the marketplace. We expect that going into fiscal year '05, we'll have 31 games to that market. So we have a lot of work to do there still. But we have had our best game, Wheel of Fortune, up and running in that marketplace. And as expected, it's our best game. So we are very satisfied with kind of the initial activity in what would be called our first Class II direct effort.

Okay. In markets outside of Alabama, can you give us a timeline on which quarters you might be entering markets like California and Oklahoma, and if you will go into that strictly with your Class II product, or if in Oklahoma you think you might be able to go into that market with a video lottery -- I'm sorry -- a video poker product?

Well, you know, I mean I think that we really have said that Class II is -- there's two aspects of it. One, that it is a subset of a bigger opportunity called Central Determination. And at Central Determination in all of its forms, Class II, what some people have remarked on as Class 2.5 and Class III Gaming, is going to be manifested in numerous jurisdictions. New York is a Central Determination market. And so generally speaking, those opportunities are going to continue to present themselves. But the bigger issue for us from Class II from a timing perspective is that Class II really forces the gaming debate in numerous jurisdictions. A great example of that I think is Texas, where there is some amount of existing gaming allowed within that jurisdiction in the form of bingo, that in effect, there is now some federal rules that allow for electronic forms of bingo to be played, what we commonly refer to as Class II -- you now have a potential for gaming machine introduction in a state that otherwise has not regulated or has any means of taxing that kind of opportunity. I think the initiation of gaming debates that results from Class II is the most relevant aspect of the entire activity. And trying to predict what necessarily will be the next Class II marketplace is pretty difficult for us to do. In the case of Oklahoma and the case of California, it appears that it will not be Class II product deployed there. I said in California, Class III expansion appears that it will preempt any need for Class II. And although there may be some taxation rate differences between the two, generally speaking, we think that Class III Gaming is much more straightforward for the player and will outearn a Class II device by a substantial factor.

In the case of Oklahoma, the modifications of Class II have everything to do with trying to get bingo in its pure form to play much closer to a gaming machine-like experience by having less interaction per game between the player and the box. If you can get those interactions to literally -- to the point where a player initiates the game and an outcome is then determined as opposed to the player requiring additional initiation, that plays an awful lot like a Class III device and that's why I've kind of given that designation of Class 2.5. We have a product internally that we dubbed the Dob (ph) Genie that, you know, had to do with technological activity that probably would be boring for this call. But that Dob Genie gets us to what we call Class 2.5, and that's the product that will be in Oklahoma.

That's a great answer. Thank you. Final question for me is, do you plan to link your games on others networks? Or do you plan to link -- like in Oklahoma for example, some of their current private competitors out there -- do you plan to link games together both on your network, on their networks? Or do you plan to keep that proprietary?

As you know, we are very comfortable with our own distribution of our own games. And so, we've called that out in the past as a real reason for us to get into Central Determination, to get into server-based gaming, so that we can control distribution of our games. Nonetheless, there's going to be markets where it makes sense to align our game creation with the distribution of third parties. And we've demonstrated a willingness to do that. As mentioned in Florida and in Washington, we already provide our games to a third-party system that's deployed by Sierra Design Group. There may be other discrete opportunities for us to do that.

(OPERATOR INSTRUCTIONS). Ray Cheeseman, Jeffries & Co.

Congratulations on your performance in some of your new markets, specifically New York and Alabama. I was wondering if you could give us any guidance for when you expect the largest opportunities in New York to open and when you expect the possibility might come about for the two extra tracks in Alabama to open up for you?

Well, in New York, I think that we have visibility for one more track opening up in the middle of the summer. And then there is some question as to when the big tracks will really open. But I think it appears that in the case of Yonkers and Aqueduct that it may be in calendar '05 for both of those.

In the case of Alabama, as we mentioned, the Senate has passed a bill. And the legislative process will really kind of occur at it its own pace. But we think that going into fiscal '05, that we will have clarity in Alabama, both what kinds of devices will be accommodated as well as what venues.

Robin Farley, UBS.

Just a follow-up. I know you were commenting on how happy you are with the beta test in Alabama. Did you -- I don't know if you had any commentary on the beta test you were doing in the California casinos for your Central Determination System.

Due to the fact that the compact negotiations are where they are, we have decided not to deploy units in California at this time.

Okay, all right. Great, thanks.

David Barteld, Wells Fargo.

Most answered. The remaining one though was tax rate looked a little lower in the quarter -- 36.5 percent a good number going forward?

We adjusted the tax rate in the second quarter such that we think the tax rate for all of '04 should be 37 percent.

There are no more further questions. Please continue at this time.

Well, again, thank you, everybody, for joining us on this call. We obviously are pleased by yet again another record quarter, and remain very optimistic that new market creation is going to sustain growth at IGT, such that we can reach our targets throughout at least this coming fiscal year and likely for several years thereafter, given there is just so much discussion for new gaming in so many distinct jurisdictions. Again, I appreciate your time and look forward to talking to you again next quarter. Thanks, bye.

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