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After what was looking like a day of indigestion for IGT bulls, the stock closed flat. The good in the quarter outweighed the bad and guidance looks conservative.

We don’t want to regurgitate the quarter, we will leave that to the sell side historians.  We’d rather focus on the future.  Hopefully, you’ll find our takeaways interesting and forward looking. 

While others are focused on the slow acceleration of replacement demand, we think the big negative issue for IGT is in the participation segment.  It’s going to be very difficult for the company to grow this business.  For IGT, we view participation similar to a casino.  The problem is unlike a casino with no growth that spends 6% of revenues on maintenance CapEx, IGT spends around 17%.  That eats into ROI big time.  At least for WMS and BYI, their participation segments are growing.

Potentially outweighing the participation drag, at least for the near and intermediate term, is the impressive margin gains.  IGT’s top line missed big due in small part to the participation segment but mostly due to international sales.  However, not only did the margins more than offset that, the improvement looks sustainable – enough so that guidance looks conservative for once.  We expect that better margins will carry IGT until replacements inevitably takes off and new markets begin to provide growth.  We will be focused on the declining ROI in the participation segment down the road.

Here are some of our specific forward-looking takeaways:

  • In North America, IGT finally met our expectations.  For the first time in 6 years, IGT shipped more replacement units in its F1Q than its F4Q.  For most operators, December is a seasonally better replacement quarter than September, but since IGT’s fiscal year is in September (which is usually companies’ most promotional quarter) that hasn’t held true for them.  We suspect that this reversal of trend means that replacements in December were much stronger than our estimated 9,300 replacements shipped in September.
  • So much for annual price increases being a given.  For as many years as we've covered this space, annual price hikes were a given.  These last few quarters have demonstrated that this isn’t the case anymore… whether you blame it on mix or selling what would normally be ‘discontinued’ product lines or deeper discounts –the numbers don’t lie.  While we still don’t believe that price is the main determinant for operators when buying games, it’s clearly become a factor and with the heightened competition, suppliers need to play the price game.
  • Despite Patti’s assurances that international product sales were strong this quarter, the numbers tell a different story.  This is the lowest unit ship quarter for international in over a decade (excluding Japan).  The company still maintains that they expect international unit shipments to be up YoY with little rationale as to why aside from guidance from their customers that the second half of the year should be better and roughly 1,500 for sale units to Italy.
  • Margins were very good considering the low number of shipments.  Systems and software sales must have been good this quarter because they carry margins of north of 70% which coupled with the higher mix of non-box sales clearly helped this quarter.  The 1,000 Mexican units also had very high margins despite lower ASPs since they were fully depreciated.  Going forward, the company expects that game sale margins will be 200-300bps lower than F1Q11 – partly due to another promotion ala– Dynamix that they plan on introducing shortly.

Gaming Operations:

  • Well, at least IGT finally admits that “the installed base isn’t expected to grow meaningfully this year” or at all if we excludes the Italian units.  On the bright side, yields finally stopped declining – although one can say that the removal of the incremental Alabama units from Victoryland helped here.
  • Some of the increase in margin is also due to the consolidation and simplification of platforms which materially decreases the installation and refresh cost.  The company expects margins to be 150bps lower for the next few quarters – which is still above prior guidance of 58-60%.