International Game Technology PLC (IGT) 2004 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the IGT first quarter 2004 earnings release conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session with instructions given at that time. (Operator Instructions). As a reminder, this conference is being recorded. I would now like to turn the call over to over to our host, Director of Investor Relations for IGT, Mr. Rich Baldwin.

Thank you, Chuck. Good morning everybody and thank you for joining us today. Also on the call today from IGT are 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 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'll turn the call over to Maureen Mullarkey, our CFO.

Thanks Rich and thank you for joining us today for our first-quarter conference call for the fiscal year 2004. We're pleased to announce today that IGT reported another record quarter with our results marking the 16th consecutive quarter in which our earnings have increased from the comparable prior year period.

During the quarter, both income and diluted EPS from continuing operations improved 38 percent over the same quarter last year, primarily resulting from strong ticket-in/ticket-out-driven replacement sales volume, higher international product shipments, significant growth in our installed base of recurring revenue gains and expanding gross margins within both of our business segments. Once again, I would like to communicate that our record earnings reflect the commitments we've made our customers to be the leading provider of gaming machines, platforms and systems.

During the quarter, we were able to deliver on several of our internal objectives. Our continued focus on increasing our manufacturing efficiencies resulted in record production levels during the quarter. In addition, we were able to achieve better price realization on our for-sale products by continuing to provide our customers with the deepest library and broadest array of gaming content across all of our product offerings.

Lastly, within our proprietary gaming business, we were successful in further penetrating the higher earnings Native American gaming jurisdiction and in our efforts to increase our mix of wide area progressive gains. Overall, I'm extremely pleased with the first quarter results and the execution of our internal objectives has culminated in record quarterly results and significant cash flows. We're off to a great start for fiscal 2004. With that, I'm now going to discuss the financial performance and operating highlights of our two business segments. I'll then turn the call over to T.J. for some closing remarks and then we will open up the call for Q&A.

In product sales, revenue during the quarter totaled 331 million, an increase of 37 percent over the prior year, primarily due to strong domestic replacement demand for our products, driven by overwhelming acceptance of our ticket-in/ticket-out technology and our industry-leading game design efforts. Our international operations also posted record results due to our market leadership position in the casino market, and I'm happy to say, strong performance by IGT Japan. Total quarterly shipments at 46,100 were comprised of 22,600 domestic and 23,500 international shipments. Consolidated average prices were 7200 for the quarter, a decrease of 11 percent from last year's 8100 and a 13 percent sequential decrease from the 8300 in the September quarter. As we discussed at length, the mix of international shipments can influence both average prices and gross profit margins, and that is the case in Q1.

Domestic shipments comprised 49 percent of the total in the current quarter; that compares to 65 percent last year. Domestic ASPs totaled 10,500 for the quarter; that is an increase from 10,000 in the prior year and 10,400 in the sequential quarter. That is primarily due to stronger pricing realization and a greater mix of systems related revenue resulting from the Acres acquisition.

International ASPs were 4000 for the quarter; that's down from 4700 in the prior year and sequential quarter is, again, due to Japan, as I previously mentioned. Product sales growth profit margins in the quarter totaled 50 percent; that is in line with prior guidance and versus 48 percent in the prior year, due primarily to improved operating efficiencies related to record production volume, as well as increase in domestic ASPs. During the quarter, we produced a record 34,600 machines in our Reno manufacturing facility versus 26,400. I'm also happy to say that we posted new high water marks for our daily and weekly production levels of 530 and 2500 machines, respectively.

While we're on the topic of our Reno manufacturing facility, I'm also pleased to communicate that IGT recently received the ISO 9001 2000 certification from the SGS (ph) International Certification Services. This certification is a testament to the hard work of our ops employees and it is crucial to our global production and sales efforts.

Looking forward, due to the conservative view on the geographical mix of product sales, the contribution related to higher EZ-Pay related systems, the Acres acquisition and international parts revenue, we expect the consolidated growth profit margin will again fall in the range of 50 percent for the remaining quarter of fiscal 2004.

Drilling a little deeper into product sales -- domestic product sales, as I mentioned, totaled 22,600 and were comprised of 73 percent replacement sales and new at 27 percent. Domestic replacements totaled 16,400 due to strong sales across all of our markets. Some of the larger replacement shipments in the quarter included within Nevada, the Stratosphere at 600, Sunset Station 600, Boulder (ph) Station 500 and in the eastern region, Paris/New Orleans (ph) at 600 and in East Chicago, 500. Given our strong replacement sales performance during the quarter, we are on track to meet our previous target of -- and current target -- of 60-65,000 domestic replacement sales in the current year. As we commenced last quarter, we announced 11 multiyear replacement programs with virtually all of the major casino operators throughout fiscal '03. That said, we will continue to fill those orders while at the same time, pursue the next wave of agreements with those same customers, as well as new agreements with the customers.

New and expansion units totaled 6200 during the quarter and were concentrated in the Canadian casino and video lottery markets and to a lesser extent, across our midwestern riverboat markets. Some the new expansion units in the quarter included 1400 units to the new casino Niagara. IGT has market share of 52 percent at that property; that compares to our previous share of 44 percent, so that is an increase, and it is in line with our East Coast market share statistics and our Canadian market share statistics. We also shipped 1300 machines to the Alberta Gaming Lottery Corporation with a 40 percent share.

In riverboat markets, we shipped 1100 new games with an aggregate share of 75 percent, and in Miami with the cruise ship markets, 600 games with, again, a market share of 75 percent. (indiscernible) this morning, you may have noticed we had the announcement with Coast Casinos in which Coast has agreed to purchase 2500 gaming machines from IGT, representing 100 percent market share for its new South Coast resort scheduled to open in late 2005, and we're very appreciative to Coast for the quarter.

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 are 146 TITO systems in operation; that is an increase from 127 at the end of Q1 '03 and 137 at the end of Q4. In addition, and with the recent closing of the Acres acquisition, we're now the leading provider of systems product offerings within the domestic gaming markets with almost 300 total systems currently (indiscernible).

The other primary driver of replacement demand is our extensive game library across our spinning reel, video spinning reel and video product offerings. Our top-selling video spinning reel games in the quarter included -- Cops N' Donuts, Money Storm, Kenny Rogers, Phone Tag and Uncle Sam. Our popular video scenes included Hexbreaker, That Girl, Ghost Island and Wild Taxi, so the New Yorkers in the audience can relate to Wild Taxi. Our top selling spinning reel game for the quarter included Triple Double Wild Cherry, Triple Stars and Triple Double Stars.

Internationally, we had a fantastic quarter with product shipments totaling 23,500; that is an increase from 10,400 in Q1 of '03, due primarily to strong machines sales in Japan, driven by our pachisuro game know Nobunaga, which is currently tracking to become our high selling game ever in the Japan market. The European casino market was also strong with record unit sales and continues as a bright star in our operating subsidiaries. (indiscernible) in Australia experienced slight declines in unit sales, but overall, our international division achieved record operating income for the quarter.

Moving on to game ops, revenues for the quarter totaled 278 million; that is an increase of 29 million from Q1 of last year. The increase in revenues was primarily related to the growth of our installed base, also increased coin-in per day per machine, as well as an improved jurisdictional mix and an increase in our wide area of progressive mix, as well as strong play levels across all of our markets. Quarterly margins were 56 percent; that is an increase of 300 basis points over last year resulting from the revenue increases mentioned above. We've been successful and are successful and continuing to improve upon our mix towards WAP (ph) and Instant Winner games, as well as our brand extension strategy. This lowers our operating costs (indiscernible) assets in the field. The go-forward trend for margins in this segment remains in the range of 55-56 percent.

The installed base of IGT-owned recurring revenue gains, which is comprised of both machines in casinos and casinos (ph) increased 400 games (ph) sequentially and by 1900 games, as compared to last year. The year-over-year growth in the casino category resulted from increased placements across the various Native American markets, Atlantic City and Canadian casino markets. The games were partially offset by the continued managed removal of end-of-live anchor stand-alone games, which amounted to 300 games on a year-over-year basis.

When you look at the increase in the installed base for the casino machines, we saw on a year-over-year basis 1200 additional wide area progressive new (ph) machines. And if you sliced it on a geographical basis, we saw 1000 additional games in the Native American market. Some of the recent popular game introductions include our penny offerings and penny games and very hot in the field right now. Our penny offering includes the Beverly hillbillies and M.A.S.H. Placements of our perennial favorites -- Wheel Of Fortune, Spinning Reel and Wheel of Fortune video -- were strong during the quarter. And in fact on a year-over-year basis, we placed some additional 600 (indiscernible) gains.

New game introductions planned for the next quarter include Dilbert, Rodney Daingerfield, Austin Powers Goldmember brand extension and our Wheel of Fortune Special Edition game, which is on our new PC-based ADT (ph) platform.

During the quarter, we also announced the signing of an agreement with Shuffle Master (ph) to buy certain slot assets from Shuffle. In summary, IGT will be purchasing the ongoing earnings stream of approximately 570 recurring revenue games and the underlying game titles and patent portfolio. Also, as mentioned in our earnings release, our current quarter results include approximately two months of operation from our recent acquisition of Acres Gaming, which is total was neutral to our first quarter earnings. Additionally, the yields within gaming operations were favorably impacted as a result of the additional week in the quarter, when compared to last year. And of course, expenses were also up during the quarter because of the additional seven days.

Moving on to operating expenses, total operating expenses for the quarter were just about 119 million versus 97 million in the prior year. SG&A for the quarter totaled 68 million, an increase from 61 million in the prior year. R&D expenses for the quarter totaled 32 million, up from 21 million last year and -- compared to revenue at 5 percent of revenue, and that is a good trend to move forward with for R&D. The increases in both SG&A and R&D were primarily due 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 R&D expenses for the quarter is 1.8 million onetime in-process R&D costs resulting from the Acres acquisition.

Bad debt expense increased 5.6 million in the current quarter, versus 3.1 million in the same quarter as last year, again, due to higher sales volume. As a percent of total revenues, operating income in total decreased slightly to 19.6 percent in the current quarter versus 19.8 percent in the prior year. And in general, you will see operating expenses trend anywhere from 19 percent to 21 percent on total revenue.

Operating income for the quarter for the first time ever for IGT exceeded 200 million at 202.2 million, or 33 percent of revenue, as compared to 150 million in the previous year, or 31 percent of revenue. As I mentioned earlier, the current quarter diluted EPS from continuing operations increased 38 percent to 33 cents per share. On the strength of our operating results during the quarter, we generated 130 million of cash from operations on income from continuing operations of 117 million. After funding various investing and financing initiatives, we increased our cash balances by 88 million to 1.4 billion at the end of the quarter. Days sales outstanding were 96 days, an improvement compared to 102 days in the prior year quarter. After adjusting for receivables acquired in the Acres acquisition, days sales outstanding would have been 94 days and total receivables decreased slightly from the end of '03.

As I mentioned before, total production in the quarter was 34,600 in anticipation of strong sales volume for the remainder of the fiscal year. As a result of these production levels, inventory increased approximately 18 million from the end of fiscal year after adjusting for Acres. Inventory turns increased to decreased 2.4 turns, as compared to -- I'm sorry -- increased to 3.4 turns as compared to 3.3 in the prior year, down slightly from the 3.7 in September. (indiscernible) the increase in SGI (ph) that you see on the balance sheet are for committed orders in the remainder of '04.

Significant investment and financing cash uses during the quarter included payment of cash dividends of 69 million, capital expenditures of 36 million, greater CapX -- greater than average '03 CapX run rate of 30 million per quarter was due to incremental installed base units, as well as five new gaming themes rolled out in Nevada during October. We also shipped games into the New York and Florida markets -- these are two very important central determination markets for IGT. We also saw the installed the acquisition of Acres Gaming for use of cash for approximately 100 million. These investing and financing cash usages were partially offset by the cash proceeds received from the sale of OES (ph) of approximately 143 million. Obviously we're very pleased with the significant cash generation achieved during the quarter and again off to a great start for fiscal 2004.

Before turning the call over to T.J., I'll conclude my remarks with earnings guidance. We recently announced the market price condition for convertibility of our zero coupon convertible debentures has been satisfied and in turn, may result in 1 cent in EPS dilution per quarter for each quarter in fiscal 2004 for 3 cents on a full-year basis. In addition, we also announced that we will redeem early all of our 400 million of our 7-7/8 senior notes on February 17 2004, resulting in 1 penny EPS dilution during Q2 and 1 penny earnings accretion in Q3.

In summary, we remain on track to achieve our earnings expectations for 2004 and are comfortable with the current (indiscernible) street estimate of $1.28 per share, inclusive of the dilution from the convert. This concludes my comments on our financial and operating results, and I now will turn the call over to T.J. Matthews for updates on our product and market development efforts internally.

Thank you Marie, and thank you to everyone for your interest in our company. It has been our pleasure today to discuss with you the highlights of our current quarter results and we're happy to be once again reporting record quarterly operating results that are a reflection of the diversified nature of our business and our continued focus on product development, market developments and prudent capital deployment. Our execution is unmatched within our niche of the game industry and demand for our products is as strong as it has ever been, which of course would not be possible without the tremendous team we have here at IGT. Our future remains bright and our expectations for continued growth remain very much intact.

Before we open the line for questions, I just want to talk about a couple of different subjects, including the topic of market development, and so what I would like to update you on some of the comments that we made last quarter.

Over the next three months, the legislatures in 44 of the 50 states will be back in session. We expect the introduction of new or expanded gaming legislation to be a major topic of debate for most of them. In addition, the governors of some of these states remain very supportive of gaming expansion and in some cases, were voted into office on a pro-gaming platform. In our review, a pro-gaming governor has been proven in the past to the instrumental in the ultimate passing of any gaming. We see such circumstance presently in New York, Oklahoma, Pennsylvania, Kansas, Maryland and California.

There is a view by some that since 2004 is an election year, legislators may not support gaming expansion. However, we're very much of the opinion that gaming expansion remains much more popular than the idea of cutting programs that support education or vital services or worse yet, raising taxes on existing constituencies.

In looking back over the past few months, we did experience some progress with gaming expansion. In November 2003, voters in Maine went to the polls and approved slot machines (indiscernible), and further voters in Indiana approved a new riverboat casino in French Lick. There is much public support for expanded gaming.

I would also like to update you today on our (indiscernible) determination system (ph) efforts since last quarter. Over the past three months, we've made great progress on development of our CES (ph) and the requisite new gaming machine platform. We continue to evaluate the regulatory environment for Class II and we're encouraged by the NIGC's (ph) commitment towards the adoption of technical regulations that will provide even further guidance. As we monitor developments in this area, we're working closely with outside legal counsel, the GLI gaming lab and tribal gaming commissions regarding the placement and certification of our products. We remain on track with our previously communicated plans to have received all requisite regulatory approvals, such that we will the operating in Class II markets that includes Florida, Oklahoma and California in 2004.

In addition to our Class II Native American efforts, we're also pursuing opportunities within the confines of charitable gaming laws. For instance, last November, a referendum was passed in certain parts of Alabama that will allow for video-based charity games. As a result, we will leverage our CES efforts and pursue opportunities in Alabama and wherever else similar laws exist.

Lastly, I'd like to update you on the New York State video lottery opportunity. In January, we shipped our first unit to the Saratoga facility, which is expected to commence operation on January 28. During the second quarter, we will also ship units to the Finger Lakes and Buffalo facilities as well. And while it has been a long time in the making, we're very excited about this opportunity, because as of today, this is the most important opportunity new market opportunity in 2004. Again, we want to thank you for listening to our conference call and we're ready to take questions.

(Operator Instructions) Steve Kent, Goldman, Sachs & Co.

Good morning. Maureen, you mentioned that you was seeing a lot of activity in the low denomination games, especially the penny games. Could you talk about how you see that rolling out, how that manifests itself in replacement sales, especially if we move to sort of an Austrian market where the majority of the games are penny machines? Does that mean you get another little mini replacement surge as quarter and 50-cents machines get switched to nickel and penny? And then also, Maureen, can you talk about how much more of an opportunity you have on margins? You basically said that it was mostly operating leverage of more machine sales. But I remember you've talked in the past about lower component expenses and some new system programs installed, which were lowering your expense structure. Can you talk about that as you see it roll out over the next couple of quarters?

Sure. As far as the video segment of our business, we have seen over the last several years actually, trends towards lower denomination games. And that was really one of the drivers too behind the adoption within the industry of ticket-in/ticket-out, too. We are also seeing more lines per game. The penny phenomenon is, like you say Steve, very reflective of Australia, and penny games are extremely hot right now. What IGT does well we think is offer game content across all segments of the casino floor. And so if there is and there does seem to be added demand on the video side from lower denominations, we have probably the deepest (indiscernible) across all jurisdictions to address these trends.

On margins, we have -- the difference in margins -- domestic margins actually, of the 50 percent that we recorded in this quarter, domestic margins were 53 percent, which is a terrific metric, and in-line with expectations. It has baked into it our new standards which we (indiscernible) standards at the beginning of the year. We do reflect lower component costs. We do think that as the year rolls through as we go through our quarters that we progressively realize and experience more and more component cost reductions. And component cost as a main driver in that it is about 85 percent of the cost of the game. And we are we have a goal of 3 percent cost reduction for the current fiscal year. And so those are some of the metrics. My guidance on 50 percent is reflective of current expectations with the mix of domestic versus international. I do see domestic margins at 53 percent or so for the remainder of the year, which is a very, very good metric and a major improvement over last year.

Okay, thank you.

George Smith, Davenport & Company.

Good morning. I may not have heard it, and if you gave guidance on this, I apologize. But on the gaming operations segment, is this type of gross margin number you think we will see going forward, something in the 56 percent range?

Just right around 55 percent. (inaudible)

And international, I think that growth there came as a surprise to many of us. Is that the type of growth that you think will see continue near-term?

I think the international growth in this quarter directly related to the success we had in Japan. We had profitable operations in every place that we do business internationally, but Japan was really the telling story. And of course, anybody that followed IGT for the 11 years that we have been in Japan know that that has been a bit of a rocky road. But we continue to try and look for the formula to have consistent success there. We're off to a good start. I would not expect that that number will be repeated in every quarter this year. It depends on the success of the new games that roll out because it generally is the market that has one or possibly two games for sale in a quarter. If you have a good game, you have a good quarter.

All right. I guess a better question would be near-term. Is that type of strength spilling over into the current quarter?

The game is still strong, but it is the tail end of the game. We have some other games that we are very optimistic about. But I don't have any strength on -- or any indication that Japan is going to be as strong in the succeeding quarters as it has been in the first quarter.

We expect to have a profitable year in Japan.

Just to add on that comment from Tom. In Japan, the lifecycle -- the sale of any one game probably only lasts maybe three or four months. And we ship about 12,500 of the Nobunaga game in Q1 and we expect total shipments of Nobunaga at about 18,000 games.

Getting back to central determination real quick, you commented on your internal development efforts. Can you comment on how or if acquisitions may be used to augment those efforts?

George, we obviously feel very comfortable with our ability to internally generate this kind of activity. This is what we do -- create game content and deliver it in the various marketplace. What is somewhat new for us and some of the determination is that not only are we required to use our platforms, but we also required use a system component to deliver that game into the marketplace. It is obvious to us because of what is going on in New York, Washington, Oklahoma, Florida being discussed in California, that central determination is here to stay. And so for us to be in markets with our own product was extremely important. We initiated that now a little over a year ago and we will have products rolled into the marketplace some time here in the next few months for us to kind of prove our concept.

And it not only -- (indiscernible) determination not only includes the idea of us being able to pull out our own system, but it includes the games that we are putting into New York, which get turned on next week. It includes the games that we have been providing to Florida for some period of time. Content has licensed in Oklahoma. We have a letter of intent for delivering games now into Alabama. Believe that we can get on-field trial to prove our technology in Oklahoma and California. This is a very major initiative. So the kinds of acquisitions that we look to augment that or any other activity that we have remain very much a focus on technology that can advance our effort forward and intellectual property. So for instance in case of the acquisition of Shuffle Masters intellectual property portfolio this past quarter, that remains very much the kind of targeted effort that we will have in terms of our acquisition policy.

Okay, thanks a lot.

Robin Farley, UBS Warburg.

With the Class II, the different jurisdictions you mentioned, can you discuss any specific legal hurdles right now that you are still waiting to overcome, or in your view, you're moving ahead of those markets and they are no longer legal hurdles?

Well there are still some legal hurdles because there is an outstanding case where the DOJ (ph) is challenging two different Court of Appeal rulings that Class II devices are not subject to the Johnson Act. There is also kind of remaining in the marketplace the need for guidance from the NIGC, in terms of their adoption of technical regulations, and they're working with GLI and GLI kind of independently creating some technical regulations. You also have just still remaining uncertainty of some amount of the gaming for instance in Oklahoma and Florida not being under compacts (ph), and so as a result having a lack of clarity there.

What it is occurring right now is substantial progress in each of those environments to make this activity much more clear, in terms of regulation. And of course, that invites companies like IGT to then participate in the market. And so you see some of the determination proposals for instance from the governor in Oklahoma to compacts with our existing 80 different gaming operations, as well as the three tracks there. You see in Alabama the implementation already of central determination. You see tribes that are more aggressive in California using the possibility of central determination as a means for furthering the compact negotiations there. And so it's very much a topic that is alive and well and I think getting more and more clarity enough so that IGT can participate in this market much more actively.

I wonder if could give us a little bit more color on what Acres added specifically in the quarter, in terms of revenues and other line items?

In general, the systems part of our business, because I think the appropriate reflection is -- or the snapshot is a better word -- is IGT systems revenues, which would include our EZ-Pay and our IGS systems offering, as well as the Acres systems. And the systems part of the business is trending at about 5 percent of total product revenues.

Is that including -- is this Acres for part of IGT for a quarter?

Yes. That is the run rate, that is the appropriate metric to use.

Is there a different margin on that business?

Acres margins run about 60 percent. So it does improve the product margins. IGT system revenues are also similar metrics.

Great. My last question is -- can you talk a little bit about your priority, in terms of cash flow, whether it is a higher dividend or more share repurchase, or what your priorities are?

Sure. We have the great fortune as a company generating significant cash flows and we have a strong heritage in returning value back to the shareholder. Historically, that has been in the form of share repurchase. In '03, I think as everyone is aware, we initiated dividend. And the dividend I believe trends at around 30 percent of trailing 12-month free cash flow. We're also still committed to share repurchase. We have 39 million shares remaining outstanding and our share repurchase authorization by the board. And you will see IGT give back to shareholders both in dividend and in share repurchase, although we may not purchase shares in each and every quarter. So we look at those sort of together in a quantity for delivering share value back to our owners.

Great. Thank you very much.

Joyce Minor, Lehman Brothers.

Maureen, can you just clarify -- I can probably back into this -- but what was the margin on the international product sales business in the quarter?

45 percent.

Great. Thanks. T.J., would you want to try to take a stab at quantifying for us at all if you are talking about Class II shipments for this year -- any targets, in terms of what we should expect quantity-wise there or in terms of a financial impact?

No, I don't think so. I think what is important for us in Class II and our ability to serve that marketplace with technology is that, obviously, IGT is the beneficiary of expanded gaming. And the fact that you can have different kinds of venues, whether it be charitable bingo, whether it be the use of lottery laws as is being done in New York to create an electronic instant lottery, or if it be using bingo laws as it is being done on tribal lands in Oklahoma and Florida; all of those create kind of the impetus for more gaming of which we are the beneficiary. Whether or not it ends up long-term as Class II remains up for some debate. As I think IGT has publicly stated in the past, we really believe that all of that activity causes for Class III debate to really be taken front and center in each of those jurisdictions as well as neighboring jurisdictions, and you're really seeing that. You are seeing more jurisdiction talking about gaming expansion or the initiation of gaming then really at any other time observed by IGT in the history of our company.

Okay. Maureen, with the greater production out of Reno, are you working out down your backlog at all, or are sort of new orders keeping that at similar levels?

Our backlog currently stands at just over 25,000 machines. And when we communicated to the street in November, I think it was closer to 28 or so. It is similar, but we have worked it down -- not because of a reduction in order flow, but because of additional lines -- we're running nine lines, two shifts.

Okay, perfect. Thank you.

Harry Curtis, J.P. Morgan.

Good morning. Can you give us a sense of your run rate R&D expense? It jumped -- is it going to continue at this level?

It did jump, and it did jump because we're spending more money in our efforts to provide the best games and the best systems to our markets, but it also jumped because of Acres. We had (indiscernible) additional 2 million run rate with Acres and then we had the other 2 million for IP R&D. I think that this year, we could get close to $120 million in R&D expense. That is 5 percent of revenue and I think that is probably -- I think probably more than double our closest competitor.

Very good, thank you.

Bill Lerner, Prudential.

Thanks a lot. Two questions. One, can you guys just update us on what you think the penetration levels of cashless (ph) are? We still kind of 30, 35-ish percent, suggesting we have several years here before that gets tapped out? And then the follow-up is related to pricing power. I recall as of October, orders in October, you took pricing up I think it was 5 percent off of a couple of years that were 3-3.5 percent. Clearly, the take-up looks good. What do you think going forward -- I guess this is probably for T.J. -- how much will pricing power annually do you have beyond that?

In terms of the replacement cycle, we still have been -- still very much believe that we are early, in terms of replacement of ticket-in/ticket-out. We're only about 33-35 percent penetrated, in terms of our marketplace of about 720,000 machines here in North America. And so we certainly have good visibility of the replacement activity being strong throughout the rest of this fiscal year and carrying into 2005. From a pricing point of view, that helps. Increased demand certainly has allowed us to get price increases in the marketplace in the past. This past October, as you said, 5 percent on overall gaming machine deliveries, but 15 percent on software deliveries because we're trying to ship very actively more and more of the value proposition from hardware to software and anticipate that we're going to be able to have annual price increases kind of in a similar range prospectively without necessarily crossing that line of creating so much customer pushback that it does not succeed in the marketplace.

Thanks.

Jeff Martin, Roth Capital Partners.

Good morning. Thank you for taking my question. Most of mine have been answered, but just wanted to get an idea of what kind of new unit demand you foresee for the next couple of quarters domestically?

Our communications to the street remains for replacement sales at 60-65,000 games, based on, as T.J. said, the early cycle we are in with replacement sales, the 11 deals that we struck last year, the new deals that we will strike this year. We do think that we will have product shipments in '04 that are similar or just slightly ahead of the shipments that we had in '03, and domestically, we shipped about 84,000 machines.

Okay. Last quarter, you said you thought it might be a little bit less --

It would be less. If the new shipments -- we think really there's been no change, because the replacement demand is quite robust. But last year, we just saw more new casinos open that are planned for this year. But because of the strength in replacements, we will be on track for similar domestic replacements '04 as compared to '03 and maybe even better.

As you know, right now a big market expansion opportunity in New York is going to roll up into our gaming operations business as opposed to product sales.

What kind of timing do you see on New York? There has obviously been continued delay. Do you see tracks getting up and running? In the near future, I know there is one that is supposed to be open in January.

There's two that are imminent. There is Saratoga, which opened January 28th, and there is Finger Lakes, which opened mid-February. So finally, that market will be up and running and anticipate that there will be a new facility thereafter, about one every couple of months or so. You have seen some -- the Aqueduct project being back on track. And so that is alive and well. The governor there of course is discussing publicly maybe expanding that effort already in advance of on the markets just getting started. So it will be interesting for us to watch. While it's good for us is that those machines that we deploy within our game ops department through the video lottery effort generally speaking are a little bit lower revenue producers than our wider progressive margin businesses. But will be very good play levels, given the high population density of New York.

Okay. And has your view changed on timing of potential reform in the UK?

No. Our timing has not changed on the potential reform of gaming in the UK. We have consistently had -- maybe a little bit more conservatively than some in the industry, but our current timing we think is a commercial opportunity for ITC in our fiscal year '06. In the UK right now, there is sort of a squinty committee and a process which is all about giving everybody a fair say. And so we are in that process right now. But directionally, everything in the UK is going along the way we had anticipated.

Great. Thank you. Nice job on the quarter.

Thank you.

David Anders, Merrill Lynch.

Great a couple of housekeeping. Maureen, do you have the number of bar crest (ph) machines that were shipped in the quarter? That was number one. And number two, for the revenue per device from the Shuffle acquisition, should that be in-line with kind of what your historical average has been? And then lastly, is there and opportunity to -- I'm assuming just because you rolled Acres in, is there an opportunity for some cost savings along the way as we work through the year, either in SG&A and R&D, or are we pretty full right now?

On Bar Crest, we shipped 6600 games into the market for Bar Crest. And the second question on Shuffle -- you asked a question about average revenue per game. The Shuffle Master games are participation games. They are lower average wins for IGT (indiscernible). I think the trend should be consistent moving forward. And the third question was Acres. No, we don't think there will be significant cost synergies. Obviously, we think there's significant revenue synergies because many of the people are technical and we are active in integrating the IGT folks in with the Acres folks. But no, we don't think there will be significant cost savings. There might even be a little bit of cost increase because our benefit programs could accelerate or enhance a little bit the combined company, but not a lot. Nothing material.

As a follow-up, T.J., when -- do you know that you are spending too much on R&D, that you're introducing too many games and that you're just not getting the return on them? What is that critical point?

David, I think that it's been well within our strategy for the last couple of the years, given this replacement cycle, that we are introducing too many games. And I think that is intentional. The goal is to make the choice to purchase from IGT an easy one. Our technology is the most sound, our game library is the most rich and the most diverse and you've probably heard me say before, we want to make it so that our customers cannot be fired for buying from IGT. And our goal is to increase market share. And during that entire period of replacement cycle, we've gone from low 60 percent penetration to now over 70 percent penetration, and I think it's been because of those efforts. So we right now feel very comfortable that we will have a continued effort to produce the most and the best games into the marketplace, hitting all different categories so that we will be the leaders in real slots and video games and video poker that hitting all different pricing policies so that we will be the leaders in for-sale products and (indiscernible). And the things that are changing is obviously we're upgrading our platforms so that we can do downloadable central determination kind of games in new venues, including New York. We're increasing our system offerings so that we are able to deliver content through a system as well as through a traditional platform. And so I think that our R&D spending at about 4-5 percent, which is what has historically been, is probably good run rate for us prospectively. The big advantage that we have is that we talked a little bit about the spend advantage, is that we have a lot of competitors spending much less money in a much more redundant fashion at much lower levels. And so I think that we're going to continue to be able to prove in the marketplace that we can advance technology in a way in which we're adding value to our customers and able to continue to having them have a great amount of their expenditures allocated to us.

Right, but on an absolute dollar basis, it's going up by about 25 percent year-over-year.

It has doubled in the last three years, and it has doubled for that reason from 60 to 120 million primarily because you've added about $20 million worth is spend from the Anchor (ph) acquisition and you added about $20 million worth of spend from the Acres acquisition, and then you have another 20 million that truly represented annual increases at IGT over the last three years, and those were as you know associated with the initiatives of more games, central determination, upgrading our system. And so I think the trend in spending is not quite as large as (indiscernible) first seen (ph).

Thank you.

Michael Reitbrock, Smith Barney.

Hi, guys. Just a couple of quick ones. T.J., are you guys still planning on doing that beta test on the Class II games? And we can get an update on that? Secondly, Maureen, just to kind of drill down into the margins a little bit more -- could you remind us -- I know that the pricing on the Japanese games is quite a lot below average, but could you quantify that for us?

On the central determination system development, we hope to be in-market with our product, our system hopefully by April. And we do intend for that to include a sale of product into the Alabama marketplace, as well as some trial rollouts, at least in California, perhaps in Oklahoma as well.

On the Japan, total ASPs internationally for the first quarter of '04 were just about $4000. That compares sequentially in the fourth quarter of '03 (indiscernible) about $4700. Japan itself in the first quarter was $2200. And again, Japan is a low payout market, very high replacement market and that type of market yields lower average prices and lower percentages, which is totally on track. It is a huge replacement market.

Okay, thanks.

David Bain, Seidler.

Hi, guys. Have you done a current kind of market share analysis with regard to systems, with the acquisition of the Acres?

We have nearly 300 systems in the marketplace and we believe that we are the market leader in the terms of number of systems, the number of machines that we have in effect wires attached to and revenues. And so we do think that we are number one in that business. We believe that it is not nearly -- it's a much more competitive environment and our leadership is not nearly as clear cut as it is with gaming machines and games. And so we're working very hard to rectify that because, as you know, we believe strategically that systems will play a bigger and bigger role in delivery of content in the future.

Can you speak a little bit about the Russian marketplace and the opportunities there? Are systems beginning to come into play? Are they becoming more mature in that respect?

This is Tom again. In terms of the Russian marketplace, we haven't been active there for regulatory issues. We have sold very few machines in the last year in Russia. Things are changing there. That market is evolving. I think IGT is becoming a bit more comfortable with the regulatory environment and you may see us report some sales in Russia. It is not anything that we are touting, but we are close to that market and we have sold a few machines there, but nothing that is meaningful to talk about.

What percentage of R&D was dedicated to central determination, or more specifically, Class II development?

We really have not broken it out in that regard. The way that I estimate we spend our money is about half on the creation of game content and about half on the delivery of that content into the marketplace. The vast majority of that delivery of content is still a terminal platform focus. And so our systems business and our central determination separate within the systems business is just a fraction of that.

And just a clarification. You said sale in Alabama, and then California, Oklahoma, I assume that's going to be revenue share?

In California and Oklahoma, I think we want to be able to prove the product to ourselves and we want to be able to work with the NIDC and the GLI to make sure that we have compliant products. But ultimately, the market place model there is revenue share for the (indiscernible) game.

And actually a final question. I assume the California placement from what I am hearing is for a couple of hundred games. Is that comfortable level for IGT, in terms of kind of going out without an NIGC approval letter?

I think machine one, you have to be comfortable putting it in on the first machine. And so there's no level beyond that in which we are more comfortable or less comfortable. Our goal of course is to kind of assert ourselves as active in that marketplace, and then just like in every other effort that we have ever had, to be number one and to try to justify why people can give all of their business to us.

Okay, great quarter.

(Operator Instructions). David Barteld, Wells Fargo.

Good morning everybody. Most answered, but in your $30 million quarterly CapX guidance, is the DOT particularly New York included in that? And are you depreciating those gains, expecting to depreciate them over 24 months?

The New York market, I think there is a guidance of 30-35 million is good that would include New York. And in New York, we're actually depreciating the gains over 36 months.

And your 600 million 09s (ph) believe -- are they redeemable at any time?

With a may call (ph).

Thank you.

Thank you.

Ms. Mullarkey, there are no further questions at this time. Please continue.

Again, we want to thank everybody for joining us this morning. We obviously appreciate your interest and we are very happy with the quarter that we just had. Thank you.

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference.