International Game Technology PLC (IGT) 2003 Q4 法說會逐字稿

Welcome to the IGT fourth-quarter and fiscal year 2003 earnings conference call. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for questions; instructions will be given at that time. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded.

I would now like to turn the conference over to Chairman of the Board, Tom Baker.

Thank you. I want to welcome everybody to our conference call for the fourth quarter and for fiscal year end for fiscal 2003.

I want to start out by making a comment for you that for 30 out of the last 31 quarters, I've been on this call as Chief Operating Officer and Chief Executive Officer of IGT. I want to talk for a moment just about an announcement that was made last week that some people have said represents something of a changing of the guard.

The first thing that I want to do today is in order of business is to confirm (sic) that the continuity of management of IGT is very sound and will continue for some time. Chuck Matheson, as Chairman Emeritus, moves into a position of respect, and I want to say that it's an honor for me to assume the position that he has held for I guess going back to 1986. He has been, more than any other person, the influence and the guiding light to myself for the past eight years as President of IGT. That influence in philosophy is something that is instilled in the current management of IGT, and I will say will be here for years to come.

T.J. Matthews is somebody that I've worked with for two years, almost two years since, since the acquisition of Anchor Gaming. In his role as Chief Operating officer, he is ready to run this company in every way.

I will continue to be a working Chairman, but the operations of the Company and the responsibility for the executive management of the Company will be on the shoulders of T.J. and his management team. This is the first conference call that T.J. has participated in as CEO. At this time, I'd like to turn the call over to T.J. Matthews.

I appreciate that. Obviously, I get the good job of getting to announce the fact that IGT reported yet again another record quarter. These results mark our 15th consecutive quarter in which our earnings have increased from the comparable prior year period.

For the current quarter, excluding certain charges in the prior-year quarter as we discussed in our press release, both income and EPS from continuing operations improved 29 and 32 percent, respectively. Our strong domestic replacement sales volumes, in addition to our increased profitability within our product sales and gaming operations business segment, were the primary drivers of a record quarterly results.

As we announced last quarter, we entered into a definitive merger agreement with Acres Gaming and are pleased to communicate that was successfully closed the transaction in late October for a cash purchase price of approximately $125 million. We would like to reiterate to you today the strategic importance of this acquisition to IGT. This acquisition reflects our long-term commitment to the systems business, it puts us, in fact, as the number one system provider in the industry, and we're very excited about the opportunities that will result from this combination.

Going forward, our primary goal will be to develop the combined IGT/Acres product offering for our customers while at the same time-consuming to provide IGT and Acres customers with the broadest array of system offerings in the marketplace today. We estimate the acquisition will be neutral to slightly accretive to EPS during its first year.

During the current quarter, we announced our intent to sell our OnLine Lottery Systems provider, IGT OnLine Entertainment Systems, or OES, to Scientific Games Corporation for approximately $143 million in cash. We now expect to close that transaction imminently and during this last quarter, we also closed the previously announced sale of our pari-mutuel wagering business, United (indiscernible).

Upon completion of the OES sale, IGT has successfully divested itself of all the noncore assets there were acquired from Anchor Gaming during that merger and will realize the total consideration approaching $400 million.

With that, I am pleased to communicate that for the first time in two years at IGT, our sole focus is being the very best in the slot machine business -- being the best in the development and delivery of games, platforms and systems across all of our worldwide markets.

We are obviously extremely pleased with our accomplishments over the past twelve months, another record year, and our record earnings reflect the diversity of our product offerings, the breadth of our markets and our continued efforts to provide our customers with the best technology in game content within the gaming industry today.

As a result of our industry-leading technology and game content, we are able to improve upon a sizable market share position, which currently stands at approximately 70 percent of the domestic slot machine market, and that marketshare has been growing.

In addition, our TITO advancements continue to drive further replacement demand and our execution is unparalleled within industry, as evidenced by standing margins with our product sales and gaming operations business segment. All of this has resulted in record operating margins of approximately 30 percent.

Looking at our investment-grade balance sheet, it remains the strongest within industry and we continue to manage it well. In late January of 2003, we capitalized on a very attractive convert market with issuance of convertible debt securities for total cash proceeds of $575 million to the Company. We did that concurrent with a share repurchase of 7.1 million shares. In fact, we continue with our historical capital deployment initiative of open marketshare and debt repurchases, acquisitions of technology and intellectual property. We also initiated a dividend during the June quarter of 7.5 cents, an increase (indiscernible) 10 cents during the September quarter. Lastly, we delivered on the promise to improve our working capital by the end of the fiscal year, continuing to manage receivables inventory aggressively.

I'm now going to turn the call over to our CFO, Maureen Mullarkey, who is going to discuss the operating performance and the business highlights of our two operating segments, and then we will open up the call for questions and answers. Then I will end the call with some closing remarks.

Before I begin, I'd 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 conditions 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 a 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 28, 2002 and other public filings made with the Securities and Exchange Commission.

This call, the Web cast of the call and its replay are the property of IGT. It is not for rebroadcast or for use of any other priority without prior written consent. If you do not agree with these terms, please disconnect now. By remaining on the line, you are bound to the terms.

Well, we had another great year. Before I start, I'd like to just remind folks that today I'm going to concentrate on the current quarter results and direct everyone to our press release for a more detailed year-over-year comparison for both the fourth-quarter and fiscal year results.

Revenue during the quarter totaled 272.8 million, an increase of 25 percent over the prior year, primarily due to strong replacement demand for our products, driven again by the overwhelming acceptance of TITO technology and our industry-leading game design effort.

Total quarterly shipments, at 32,800, were comprised of 20,700 domestic shipments and 12,100 international shipments.

Average selling prices were $8,300 for the quarter, an improvement of 17 percent over 7100 in the prior year and the 4 percent sequential improvement from 8,000 in the June quarter. The improvement in consolidated ASTs (ph) primarily related to the greater mix of domestic versus international shipments, as well as stronger price realization.

Domestic shipments comprised 63 percent of the total current quarter, compared to 56 percent last year. Domestic ASPs totaled 10,400 for the quarter; that's an increase from 9,400 last year and an increase from 10,000 in the sequential quarter -- again, due to stronger pricing realization.

International ASPs were also up at 4,700 for the quarter, up from 4,200 in the prior year and 4,300 in the sequential quarter, due primarily to a favorable geographic and product mix, as well as favorable FX rates in Europe and the UK.

Product sales gross margin in the quarter totaled a record 52 percent, versus 45 percent in the prior year, resulting from several factors; these include increased EZ Play-related systems revenue, improved operating efficiencies related to higher volumes, as well as the increase in ASPs mentioned above. Of the 700 basis points improvement on a year-over-year basis, approximately 300 basis points of that was related to the increased volume.

During the current quarter, we produced 27,700 games in our Reno manufacturing facility, versus 21,000 last year. That brings the total for the fiscal year 2003 to 105,000 games, compared to 83,000 last year, an improvement of 26 percent.

Looking forward, due to a conservative view on geographical mix of product sales, the contribution of higher margin EZ Play-related systems revenue, conservatism on that substrate, we do expect that gross profit margins on product sales will trend at just around 50 percent for 2004.

Let's spend a little bit more time giving a little color on the unit sales in the quarter. Domestic product sales totaled, as I mentioned, 20,700, comprised of replacement sales at 75 percent of the total and new and expansion at 25 percent.

During the quarter, we realized 15,500 domestic replacement sales -- a new record; this brings the total for the year at 58,000, surpassing our original goal of 50,000 games for 2003.

We shipped an additional 1,000 machines into the province of Québec during the quarter, completing the previously announced order for 8,400 games that we commenced in '03. In addition, we shipped 1,100 units to the Alberta Lottery during the quarter as part of a 3,000-machine order.

As previously discussed, the Canadian provinces of Québec and Saskatchewan have been a strong source of replacement demand in '03. In '04, we expect to benefit from the replacement programs in the provinces of Alberta and Manitoba, but it's widely known they will not be of the same magnitude as the Canadian replacements during fiscal 2003.

New and expansion units totaled 5,200 during the quarter and were concentrated in the Midwestern riverboat markets and to a lesser extent in the Native American markets of New Mexico.

Large shipments for the quarter included 1,100 units to the Argosy Riverside Casino in Illinois, where we got 70 percent market share, and 800 units to the new Route 66 Casino in New Mexico, where we garnered 72 percent marketshare.

Demand for IGT systems often continues to gather significant momentum. Our EZ Play Ticket-in/Ticket-out system continues to be the primary driver of our domestic replacement sales during the quarter. We installed our 148th system, an increase from 95 at the beginning of '03 and an increase from 134 at the end of June.

In addition, with the recent closing of the Acres acquisition, we are now the leading provider of systems products with the domestic gaming markets with a total of 276 systems currently in operation. As always, our extensive game library across our mechanical spinning reel, our video spinning wheel and our video poker products continues to stimulate replacement demand and we continue to raise the bar or with our game development efforts.

During '03, we introduced over 70 new game themes on our four-sale slot machines. Our top-selling games for fiscal '03 included Triple Stars, Money Storm, Lucky Larry's Lobstermania, Tabasco and Enchanted Unicorn.

We had a great G2E back in September and some of the game introductions that we will introduce in the near-term include Reel Touch Bucks Ahoy, Snow Globes, Max Action and Ferrell's (ph) Fortune.

Internationally, units totaled 12,100 during the quarter, versus 13,600 in the fourth quarter of last year, due primarily to fewer sales in Australia and the UK, offset by increased sales into the European Casino markets. The business conditions in Australia, as we've mentioned over the past several quarters, continue to be challenging due to the restrictive government anti-gaming regulations, known as harm minimization, which continues to adversely impact both the operators and the suppliers across the market.

Despite fewer machines sales, current quarter operating income increased approximately 50 percent over last year and in total, our international operations achieved record operating income for the year, primarily resulting from a strong performance in the higher margin European casino markets and because of increased parts and conversion sales in Australia and favorable exchange rates.

Moving onto game operations, revenue for the quarter totaled 274.6 million; that's an increase of 11 million from Q4 '02 and an increase of 12.9 million from the sequential June quarter. The increase in revenues is primarily related to growth in our installed base, increased coin-in per day per machine, and improved jurisdictional mix and increase in play levels across most of our markets.

Quarterly margins were 57 percent for the quarter, an increase of 200 basis points over last year, resulting primarily from the revenue increases mentioned above, as well as favorable interest rates during the quarter.

We've also been successful in improving our mix towards Wide Area Progressive and instant-winner games and by deploying on our brand extension strategy. This lengthens the life of our assets and therefore lowers depreciation expense. Going forward, the more normalized gross profit margins in this segment, as we've mentioned previously, should range between 54 to 55 percent.

The installed base of IGT-owned recurring revenue games, which is comprised of machines in both casinos and racinos, increased 400 games sequentially and by 1,900 games when compared to the last year. The number of games in the Casino Market category was aided by increased number of installations, primarily in the Native American markets of California in New Mexico. These gains were partially offset by the continued managed on a removal of what we call the End of Life former anchor stand-alone games; we removed 100 of these games sequentially and 400 on a year-over-year basis.

Major casino contributors in the quarter included, in California, 150 additional games and in New Mexico, 100 additional games.

During fiscal 2003, we introduced over 20 new recurring revenue game themes and brand extensions. Our perennial favorites include Wheel of Fortune, The Price Is Right and Megabucks. Recent popular game introductions include UNO, Magic 8 Ball and M*A*S*H. Highly anticipated new game introductions recently debuted at the G2E include Dilbert, Rodney Dangerfield, the Twilight Zone, and Wheel of Fortune Special Edition, which will be deployed on our new AVP PC platform.

Some words on operating expenses -- total operating expenses in the quarter were 116.2 million, versus 98.4 million in the prior year. SG&A expenses for the quarter were 72.6 million; that's an increase from 60 million in the prior year. R&D expenses for the quarter totaled 27.3 million, up from 22.7 million in last year. Both SG&A and R&D increases are due primarily to additional employee-related costs, including salaries, wages and health benefit costs. In SG&A, we also had higher advertising expenditures.

Operating income in the quarter reached record levels at 182.3 million, or 33 percent of revenues, as compared to 143.9 million in the previous year, or 30 percent of revenues.

As T.J. mentioned earlier, EPS from continuing operations increased 32 percent to 29 cents per share, excluding certain charges in the prior year as discussed in our press release.

Cash flow on the balance sheet -- we had an extremely good cash flow year and quarter. Cash flow provided by operating activities totaled 430 million for the year, as compared to 563 million last year. The decrease in operating cash flow for the year primarily resulted in increased trade receivables of 50 million related to higher revenues, increased notes and contracts of 32 million related to sales in the markets of New York and California primarily, and increased inventory balances due to higher gaming machine demand.

We did see an improvement in Days of Sales Outstanding. DSO at the end of September was 100 days. That's an improvement from 106 days in June, the sequential preceding quarter, and 105 days at the end of last year.

Inventory turns remain consistent with this last June at 3.7 times for September and is an improvement over the 3.5 turns last year.

The fourth quarter was a fantastic quarter for cash flow generation. During the quarter, operating cash flows improved to 201 million over an average of the preceding three quarters of 76.2 million. The increase in operating cash flows during the quarter primarily resulted from increased collections on receivables of approximately 45 million, decreases in tax payment of about 40 million, and the timing of liability payments.

The strength of our balance sheet continues to provide us with unparalleled flexibility to capitalize on strategic and financial opportunities. We currently enjoy investment-grade ratings of BBB and BAA3 by S&P and Moody's, respectively. We also returned approximately 222 million back to our shareholders last year in the form of share repurchases and dividends.

I'm very pleased to communicate these financial results for 2003. We've had a fantastic year and are as excited as ever about the future.

That concludes my comments on the operating results. Now, I will turn the call back over to T.J.

Well, I think we're just going to open it up for questions that people might have for us.

(OPERATOR INSTRUCTIONS). Steve Kent with Goldman Sachs.

Good morning. A couple of things -- first, you didn't mention really much about the potential for Class Two games, which seems to be pretty significant and with some of the recent news and also because you did show a version of what you could do with Class Two. What's the plan there? Is that partially some of the R&D? Will you be spending more money on that over the next twelve months?

Second, can you give us a little bit more color on the Accounts Receivable? They do look like they are increasing higher than we would have thought. Sort of how do you look at that? How are you managing that, and where are those Accounts Receivable going to?

I will address Class Two. Obviously, one of the things we want to do at IGT is develop new markets for our products, and the world of Class Two would have been largely relegated to the sideline because the rules there have been very unclear. In fact, the federal government and the states in which Class Two devices have been operated have been at odds over what is a Class Two-defined product. That appears to be changing some with NIGC (ph) opinion letters that have been issued to other companies, making it much more an available opportunity for IGT. So, as you have mentioned, we do have a product that incorporates both system and terminal, as well as our standard game library technology, for deployment in the Class Two environment. We will be the only company in Class Two environments that has access to our entire game library. So we, of course, wanted to ensure the marketplace was aware of that and knew that we were, in fact, developing products accordingly. We hope to be in the marketplace early next calendar year, sooner if possible, and don't necessarily expect any financial impact from this kind of opportunity until fiscal '05 or beyond.

If clarification of the rules immediately affects Oklahoma and Florida and also start impacting, potentially, all sorts of markets in which there are limits on the number of Class Three devices -- that would include California. So, for us, it is very much an important activity. It demonstrates our commitment to systems; it obviously reflects on the fact that our game content is in demand in all areas in which gaming devices are operated, and so we are excited about Class Two.

On Accounts Receivable, I will Maureen talk specifically about what we're doing there, but I don't think that's much of an issue. You know, that Days of Sales Outstanding is the big statistic, for me at least. That is a number that is trending down. The rest of the Receivables uptick I think is due to increased sales volume, which is, generally speaking, a good thing.

Sure, if you look at the cash flow on a quarterly basis, we actually show a source in the Receivables category in Q4, which is the first time in the fiscal year. As I've talked to many investors out there and analysts, that we did expect some of the Receivables to turn by fiscal year-end, which is in fact what happened, and it contributed to the very significant operating cash flows that we had during the quarter.

In fact, for the fourth quarter, our free cash flow, which is operating cash flow less CapEx, was in excess of net income, which is a very notable and positive statistic.

George Smith with Davenport.

I had a question about guidance that you had offered previously for 2004. I think the target was 60 to 65,000 replacement units. Is that right?

That's correct.

What percent of that could be considered -- or portion that could be considered book-to-business, or business essentially under contract, versus potential new business, if that makes any sense?

Well, our backlog presently is 29,000 machines. As you know, we've entered into a number of multiyear contracts with several of our customers. I think, with 11 of our biggest customers, we now have agreements that extend into the years 2005 and beyond, and so some portion of it is booked; some portion is representative of new markets. Obviously, all of it is a result of us really concentrating on how to accelerate the replacement cycle.

Traditionally, you've offered, I guess, a targeted earnings growth range of 15 to 20 percent annually. Is that something you still believe is intact for this year?

That remains certainly our goal for this year and beyond, and we feel very comfortable with the Street mean estimates of $1.27 at this point.

can you just remind me -- the lottery business, what did it do in revenue for the year that just ended, or more importantly, for the quarter?

You know, I don't have --.

It does about $125 million a year, and it had a very good quarter due to seasonality, and so you see that in it being the two pennies of discontinued operations.

Long-term, we think that it does fit well with Scientific Games and did not necessarily fit well with IGT.

I guess, just in thinking about the balance sheet and room to make moves, what type of acquisition, in your opinion, would be ideal? It would seem tough to make an acquisition (indiscernible) domestically, so what do you believe makes sense?

I think we always -- you know, the three things that we want to be the best at are games, platforms and systems. The opportunities for us include technology acquisitions, intellectual property acquisitions, internalizing distributors, internalizing game partnerships. We certainly have the wherewithal to go international into the markets that we already have a presence and try to expand our market share there. So I think there is a lot of small-ish opportunities in the industry that we're going to focus on and in fact, had a good year this past year, though not much publicized, on those particular efforts. Obviously, the public ones were Acres, but we did a good job of acquiring intellectual property this past year as well. That's going to continue. Whether or not there is some other bigger alternative for future collaborations, that remains to be seen. Obviously, our default use of capitalist is to get it back into the shareholders hands.

Joyce Minor with Lehman Brothers.

Maureen, do you have any general comments that you can make about the margin improvement on the product sales side of the business? Did the ninth production line effect that at all, or is there any way you can break it down in terms of the impact of manufacturing efficiencies versus product mix? Was it kind of half and half or -- (multiple speakers)?

Sure. On a year-over-year basis, we saw the 700 basis point improvement, so it's pretty significant, and I would say about 300 basis points of that was related to just the added volume. You know, we had 26 percent improvement in volume, so we are spreading fixed costs over a greater number of machines. I think about, in total, we had like $200 per machine cost reduction.

In addition to that, we had probably a similar level of systems revenue year-over-year but much higher margin this year because of EZ Play-related systems, Ticket-in/Ticket-out, which carry higher margins. In the '02 period, we had a significant percentage of our system sales to a large customer, which lowered margins.

Then in addition to that, probably 100 basis points was related to international markets. So, the (indiscernible) of course did help. That was later in the year, but we did a great job in '03, I think, of flipping the switch on a new enterprise resource planning system and getting to (indiscernible) which was in January. We had a transition quarter in March, and by June, we reached record production levels for a quarterly basis and the same in September. So, the primary driver was definitely (inaudible) demand.

Also, can you comment on the recent price increase that you put in place? Any response by customers? Any orders accelerated ahead of that price increase?

Yes. In fact, we had a lot of orders. That price increase was effective for orders after October 1, and we saw a lot of orders come in prior to October 1, such that the impact of that price increase is probably going to be the latter half of '04, but very good response.

Great. Then just lastly, T.J., just to follow-up on a question on Class Two, it's difficult for us to get as much information as we would like about sort of the size of that market that thinking about the potential growth of that. Do you have any ballpark metrics that you use in thinking about how sizable to market for Class Two games could be?

For us, I think that we mentioned that Class Two really is a subset of a bigger market opportunity called (indiscernible) Termination. It's just changing; the world is changing for game delivery in that that used to be a platform-only activity and it now requires system in many environments. That's the case not only in Class Two environments like Oklahoma and Florida, but also the case in Class Three environments in Washington, New York and in several international jurisdictions, most recently (indiscernible) conducted in Norway; that became a requirement.

So, when you take a look at the New York market, that may approach 20,000 machines in the video lottery world; it's starting off as 14,000. I think that you see that Washington market getting over the 10,000-machine hurdle, growing to 14,000 more machines.

In Oklahoma, although I think it's somewhat undocumented, that's a marketplace that is in the 10 to 15,000 range. We think that the Florida operations could easily be 5 or 10,000 machines before they are done. So, you kind of have these spatterings of opportunity right now that are (indiscernible) the termination, and so we very much want to be leaders in that world.

Where it becomes a very big opportunity is that there is substantial reluctance on the parts of numerous parties to deploy our devices where there is kind of a lack of clarity as to whether or not they are legal and appropriate in that given jurisdiction. So, the big opportunity for Class Two gaming is in markets like California, where there is a market limit, or in other jurisdictions in which bingo is offered. As a result, electronic forms of bingo can be accommodated, which is really what Class Two gaming is about. As a result, you can deploy what appear to be gaming devices that you might find in normalized Class Three environments.

As you start kind of identifying those opportunities, the market could be quite large. It's underserved right now in terms of the technology providers; it has kind of a lack of access to mainstream games. IGT obviously intends to take the leadership position to help clarify the roles for that industry, either to help move Class Two environments to Class Three, in which we can best serve them, or to understand the Class Two rules well enough that we can serve those customers with our products.

Harry Curtis with J.P. Morgan.

A follow-up on that line of questioning -- what additional clarifications, with respect to Class Two, are required for you to feel comfortable selling into these markets? For example, in Oklahoma, would you feel comfortable selling into a market where there are already Class Three games and you feel uncomfortable with the mix between Class Three and Class Two games? Is there not a regulatory issue there?

Obviously, compliance with the regulations of individual jurisdictions is crucial to us, given the fact that we have licenses in over 600 jurisdictions. So, we have to tow the line in each new jurisdiction to ensure that we stay compliant with our existing regulatory requirements.

That said, I think there is really opportunity for a leadership position in Class Two to help clarify the rules, to help distinguish between what is appropriate and inappropriate activity, to get individual gaming operations to acknowledge those rules, to adhere to them, and that would allow our entrance into those market places.

So really, your question would need to be answered on a case-by-case basis, but we feel comfortable that the gaming operations that are conducted in Oklahoma and Florida are managed by Native Americans who want to have legal gaming on their premises, and so we are anxious to help them.

Do you think that you're going to need advisory opinions on each of the new models that you bring out, or is the advisory opinion just based on the central processing unit, or the system itself?

I believe that the NIGC (ph) said that they intend to do is have an advisory opinion process for some interim period. That has issued two advisory opinions, which are public and allow us to review -- (technical difficulty) -- technical specifications required in at least two devices that have been designated as Class Two. But longer-term, they hope to establish technical specifications that will be available to all manufacturers as kind of a clear guide to what is a Class Two device.

My last question is really related to the pricing model. Do you think the pricing model changes from the current roughly 30/70 model?

I think there's a possibility that pricing is going to be impacted by more providers in the net marketplace -- yes.

Robin Farley with UBS.

I have a couple of questions. One is, I wonder if you can quantify the exchange rate benefit in the quarter and year-to-date, and I guess the revenue and gross profit line?

On a pre-tax basis -- the year, there was a $9 million FX impact positive; Sequentially nothing, so the quarter year-over-year about 2 million.

Then can you talk about your expectations in Illinois -- getting approval there by the end of the year? Is Illinois included in your '04 guidance when you talk about replacement units? Are you expecting that to be part of that?

(indiscernible).

Right, we expect that Illinois is going to have Ticket-in/Ticket-out technology deployed sometime this fiscal year and that some number of the sales into that marketplace will be included in our existing replacement forecast. The big opportunity in Illinois, of course, is should that state ever contemplate expansion.

Great. Also, Maureen, I think, in your introductory comments, you made a reference to gaming operations -- lower depreciation there. Can you just quantify what that was and how much that impacted margins this quarter?

Actually, there was really no discernible difference this quarter. We (indiscernible) probably the second quarter this year we saw like a couple of million dollars, but we have been active in what we call our brand extension strategy, really over I guess the last 18 months. We've been able to extend the life of the games in that segment. So -- and we have additional costs there were offset by that. We do see greater casino service-related costs; we are increasing our preventative maintenance out there. We did see some increased cost related to royalties, and so our brand-extension strategy has been effective in keeping normalized margins in that segment.

Okay, great. Then the last question is, T.J., you mentioned that you didn't expect any Class Two impact really until '05. Is that just because you don't expect to be ramped up in terms of volume, or is it a distribution issue?

That is for the effect of being conservative. We are jut not there in that market yet and until we are there with product, I think it's appropriate that we be conservative with those forecasts.

David Anders with Merrill Lynch.

Two questions -- Maureen, can you quantify -- were there significant shipments to Harrah's in the quarter with respect to your large order? are you starting to fill that already?

Also, could you comment -- R&D as a percent of revenue I believe was up pretty significantly in the quarter. Is that the new run-rate, either on a absolute dollar basis or a -- (technical difficulty) -- revenue basis?

Yes, I can comment that the Harrah's shipments will be in '04. We did not ship any shipments to Harrah's in '03.

Then R&D, let's see. R&D for the fiscal year was about 95 million. I would say that about 5 percent of revenues is appropriate and moving forward OPEX is 20-21% of revenue in total which has been a pretty stable statistic.

a couple of quick ones -- (technical difficulty) -- becomes a buy or build decision for you guys. Your comments would sort of indicate that you're leaning toward build. Is that a fair assumption?

The just second quick question -- Maureen, what are you guys assuming for 2004 in terms of both timing and contribution from the New York (indiscernible)?

On the Class Two make verses buy, of course, any time that we can acquire technology or intellectual property that got us to market faster, we would. However, at the same time, we're very comfortable with the folks that we have to develop products at this company and know that we have already have a game library, which is the cornerstone of any gaming devise business -- introduction into a marketplace -- that we have platforms that work. We have been working in Class Three environments with our platforms in Washington and ready for New York in terms of the termination environment. So, we know we are ready with our platform. We needed a central systems server to be able to distribute these centrally-determined outcomes to the terminal itself. We've been working on that and that's what we demonstrated at the Oklahoma show. Should it be a make-decision, we are extremely comfortable with that.

Then as mentioned before, on the question of acquisitions, we're just constantly on the lookout to see if something can augment our efforts. But I think you're right. I think the lean-to is make and I think that the big advantage our make product will have is our game library. That's not widely available.

On New York, I think our current expectation is that we would commence that part of our game operations starting in January, and then that would proceed throughout the year.

David Bain with The Seidler Companies.

I hate to keep (indiscernible) on the issue but I just want to get a little clarity on the Class Two. Have you had any discussions with Nevada licensor, agencies or other agencies?

We have. We are in constant dialogue with the regulatory agencies that oversee our activities and have shared with them some of our efforts underway already in for Class Two. Realize that maybe not widely known -- realize that our content is already, in on a very limited basis, into the markets of the Oklahoma and Florida. Obviously, we are in consultation with Nevada authorities and other regulatory authorities for that.

Okay. You mentioned that you may have something out there in terms of a field trial early next year. Would then be in a Class Two or Class Three casino? I mean, are you in queue right now for an NIGC (ph) letter?

To be determined. We will be, in Q4, (inaudible) an NIGC (ph) letter shortly. I think that to prove the technology, we haven't determined what the best environment is. Obviously, they are environments in which we could deployed a Class Two device, have it designated or not worry about what its designation is -- whether it be Class Two or Class Three -- if we choose to do that in a Class Three environment. So, that certainly is a safe route for us. We will continue to monitor that. Obviously, trying to get these devices in as many new locations as possible is important.

There's been a lot of focus on this Class Two. Realize for us, still our primary story is the sale of devices to our traditional Class Three customers. It is being augmented by an accelerated replacement cycle due to new technology, new functionality delivery in our Class Three devices. We have been very, very good at doing that and making sure that we always give people a new reason to buy our equipment, whether it be the hardware or software component. We're still most focused on the new market development that is existing in much more of a Class Three manner -- (technical difficulty) -- Pennsylvania; it includes Maryland. There is discussion in Michigan and Massachusetts presently as far as bills passed in various portions of the Legislature and continuing to be supported. So that Class Three emphasis is still what we do day-in, day-out at IGT. It's just that Class Two now has become notable enough for us to no longer ignore that market and to emerge there with the normal market leadership position that we expect from ourselves.

Just to get clarity, because it's a new area for a lot of investors, so you would wait to get an NIGC (ph) letter, but you're not in queue before you would place anything in field trials in a Class Two casino?

Well, realize what the Class Two letter advisory opinion has been about; it has been a formalized sponsoring of legal opinions being issued to try to determine what products conform to the Class Two rules. In other words, class Two, largely being designated as things that aren't Class Three, and generally speaking, center around the world of bingo. In the world of bingo, you are allowed to use electronic aids to help demonstrate that game to the playing audience, but you're not allowed to change the characteristics of bingo -- that more than one person must play, that there has got to be a common ball draw, that there are numerous requirement for a device to be considered Class Two. A lot of those are well understood. There are, of course, numerous companies -- probably some number of companies that have been involved in that product offering in the past that maybe have pushed the definition of what Class Two has been about in the past. So that's why the NIGC (ph) has weighed in, to help the states understand how to regulate what is Class Two and Class Three opinion.

You are, as a company, able to come to your own conclusions and self-enforce Class Two rules upon yourself. I think IGT, prior to submitting to the NIGC (ph), will have done that. Of course, we will be looking for NIGC (ph) legal opinions to augment the ones of our own to make sure that we're really ready for that market with a legal product.

Okay, so you will wait until that happens to stem any risk in terms of your license and what not -- (multiple speakers)?

We're going to be prudent; we are going to be prudent.

Just in terms of the titles you mentioned that you will be the only company with access to the whole game library, I think STG is using some of your titles now. Can you talk to how that's done versus the competition out there now, those totals and also, if they will continue along with that license?

We have a good relationship with STG in Washington in that they've acted as our long (indiscernible) distributor for our product in that marketplace, but our relationship has always been one in which they had limited access to our game library, as well as kind of a limited timeframe to which they have that access. We've extended that some to Oklahoma and Florida but realistically, it's still a very small portion of our library, does not necessarily include new games added to the library because we obviously have a preference to save those for our own direct introduction to those marketplaces.

Can you (inaudible) how they have done versus the competition with those titles?

I think, in Washington, we are the clear market leader, as you would expect -- well over 80 percent marketshare with our games and, in most cases, our box and platform housing those games. In Oklahoma and in Florida -- well, in Florida, I think, in effect, you'll see that our games are going to be a similar kind of marketshare or greater. In Oklahoma, I think it's just too early to tell but I would be very surprised if, by the time IGT is direct in that marketplace, exclusive of the long-standing relationships that I think both multimedia and STG (ph) have done for themselves and have done on behalf of the tribal operations to which they deserve credit -- with the exception of that, we anticipate getting our normal marketshare or better.

Just a final question on this -- if you look at Oklahoma and California, which do you deem as more attractive in terms of (indiscernible)?

I think that both of those markets are more likely to be Class Three opportunities over time than Class Two opportunities. California clearly has a deed the revisiting the contracts with the tribes. They are, in fact, required to do so. I think Native Americans have expressed a desire for more games, and it seems like the ground is fertile there for a good negotiation between the states and the Native American tribes for them to compromise on an increase in the number of Class Three devices in that market. If they do that, that (indiscernible) precludes the need for substantial Class Two introductions.

I think you see the same Oklahoma, where there has been a lot of discussion between the Native Americans and the State of Oklahoma in trying to determine what is an appropriate compromise for regulation of the activity and legality of the devices. It's clear that if it became Class Three gaming in agreements to compacts between the gaming operations and the states, that that would clarify much of the cloud that surrounds the activity today. So that seems to be the most likely outcome. Should neither of that happen, California is a much bigger gaming market potentially than is Oklahoma for Class Two devices.

Thank you. Our next question is from Jeff Martin with Roth Capital Partners.

Good morning. I wondered if you could give us an idea of where you think the market is in terms of Ticket-in/Ticket-out penetration. What percent of machines are print-enabled right now?

I think that we've gone out and talked about -- about 30 percent of the installed base in the marketplace now is utilizing our 8960 platform, so we still have a substantial amount of existing IGT boxes utilizing all their technology to upgrade or replace -- I guess, generally speaking, replace -- for us to facilitate Ticket-in/Ticket-out. Of course, we continue to expand our marketshare.

The constant effort there is not to focus just on Ticket-in/Ticket-out, but to constantly offer greater functionality. So you to see our games becoming more complex and demanding, that we have faster processing, utilize more memory, have better audio and better video. You seek multidenominational games becoming more important; you see multi-lines becoming more important as we go down into denomination. So we're doing numerous things to make sure that the replacement cycle stays robust and expect, as results, that the replacement cycle has at least a few more years in it.

What percent penetration do you think will be cash less-enabled by the end of the 2004 calendar?

I think, by the end of 2004 calendar -- the end of our 2004 fiscal year. We've been talking about our penetration rate going from 30 percent to 40 percent. I think that the market might not yet be over the 50 percent mark for cashless gaming. I think it's clear to us that the early adopters are going to a 100 percent cashless environment, and so you can anticipate that.

Okay. Then on the systems side, from what I'm hearing, Aristocrat CDS platform is not performing to the way that a lot of casinos would like it to perform. Do you see a lot of replacement potential there to put in a anchor system, or now an IGT system, into facilities that have CDS systems that aren't performing?

I think that you'll see us invest in the systems business to be the preeminent provider of gaming systems. We anticipate that will allow us to expand our presence into new markets but of course, it's going to require that we displace existing competition in the current markets as well. We have really done that. If you take a look at our EZ Play offering, which is again a system-enabled feature for gaming terminals, we are now in 148 different casinos -- in some cases, acting as an integrated systems to existing provider; in most cases, acting as a parallel system to the existing provider, meaning that we have a conduit for delivering new applications to those casino environments already. We intend to take advantage of that.

When you have kind of the bonus theme activity that is coming to this merger from Acres Gaming, that kind of opens up some exciting opportunities for us to deliver real value-add applications to those marketplaces. So, it is an opportunity.

A final question -- Maureen, do you care to take a stab at what percentage of unit shipments next year will be in the form of replacement? It was -- what -- a 75/25 mix in fiscal '03. Do you care to take a stab for '04?

We are on the record that our new goal for replacement mixture is between 60 to 65,000 games, so that's the trend to you.

With a similar ratio -- 75/25?

I would say new sales next year -- well, we had a great year for new sales in '03. We had the Borgada and the Seneca (ph). We had Dry Creek; we had (indiscernible); we had Tuscany; we had Route 66, so quite a lot of new sales this year.

I would say that the new market for next year is really New York, but that's going to flow through our game operation. So, we might actually see slightly lower new sales next year, but the replacement cycle is alive and well and we are predicting greater replacement sales for next year.

(OPERATOR INSTRUCTIONS). We have a follow-up from David Anders with Merrill Lynch.

Maureen, I guess for you, for the 15-20 percent longer-term earnings per share growth, that includes the convert, correct? The dilution (indiscernible) longer-term?

I guess we're not assuming that. On the convert, a lot (inaudible) consistently on operating income has been 15 to 20 percent growth in the earnings of the Company. That's adding operating earnings on a year-over-year basis through better volume, better margins, cost-containment, the best technology. How a convert works is that, if our stock trades -- the first measurement period would be 12-5 to 120 (ph), that's December 5th to January 20th. If the stock trades for 20 on 30 consecutive trading dates over $33.90, then we would add about 20 million shares to the base, which is a 3 to 3.5 percent dilution.

We have no further questions at this time. Please go ahead with your closing remarks.

Obviously, we want to thank everyone for your continuing interest in our company. It's been a pleasure, today, to discuss with you the highlights of our current quarter and the fiscal year results. We are extremely pleased with our record operating results, which we believe to be a reflection of our diversified nature of our business in its markets and a relentless focus on the product development, market development and capital deployment at this company.

Demand for our products is as strong as it's even been. Our execution is unparalleled within the game industry, and none of this would have been possible without the tremendous team we have at IGT. All of these factors have combined very well for the benefit of our shareholders and we're very confident they will continue to do so in the future. As a result, our expectations for continued growth remain very much intact -- as we talked about, goals of growing EPS and operating income by 15 percent or more a year, and comfort with the Street estimate of $1.20.

I wanted to take a moment to kind of reflect on the association that Chuck Mathewson and Tom Baker have had with the Company. Chuck Mathewson, as Chairman Emeritus now, has been associated with the Company for 20 years. During that 20 year period of time, he has overseen our stock repurchase program. We have purchased back 357 million shares since he has been involved at a price of $1.7 billion. Obviously, that is more than half the shares of the Company and reflects on what was his very strong vision for this (indiscernible) growth company. We continue to obviously extend that legacy into the future. The stock price under his watch, his association with the Company, was an increase of over 100 times.

Tom Baker, since he assumed the position of Chief Operating Officer in 1996, has overseen increases in revenues, net income, total assets (inaudible) market capitalization that have, in all instances, been at least three times. In the case of market capitalization, we have gone from a market cap of 2.6 billion to one now over 11 billion, so his association with the Company has also been during periods of great success.

So we're very glad for the services that they have rendered to IGT in the past and are glad that we're going to have their continued wisdom made available to us as we proceed forward.

One of the things that we did last quarter was we reiterated our prediction that there were going to be ten new gaming markets. We got a lot of focus today on Class Two, which is us creating market, but realize that it is the fiscal involvement in most of these states that is going to create Class Three opportunities for this company. So, we continue to stand by our prediction of ten new gaming markets in the next ten years. There are four state legislatures in session right now that are contemplating gaming bills. That is Pennsylvania; it's Ohio; it's Michigan; it's Massachusetts. Today, they're votes in three states, Colorado, Maine and Indiana, where they will be voting on various gaming expansion options.

There are, of course, the ongoing debates that exist in Maryland, and so we feel very comfortable that gaming expansion is alive and well and that, of course, we will be a primary beneficiary of that.

We also commented last week, or a lot today about Class Two. We are committed to understanding and being a leader in that business, as we talked about at length today.

Also, what we talked about briefly is the domestic replacement cycle and our continued expectations that it's going to remain robust over the next three or four years, that we have, now, 11 major multiyear replacement programs that are in place with virtually all of the major casino operators, and that we are obviously working already on the next wave of agreements with those same customers, as well as new customers, to make such commitments. As such, we're very comfortable with our guidance that we will replace 60 to 65,000 units during the course of fiscal 2004.

We thank you very much for your time today and look forward to meeting up with all of you again. Thanks.

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