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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 29, 2004
Commission file number 1-11250
GTECH Holdings Corporation
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 05-0450121
- -------------------------------------- -----------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) Number)
55 Technology Way, West Greenwich, Rhode Island 02817
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (401) 392-1000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934)
Yes [X] No [ ]
At June 30, 2004, there were 59,007,693 shares of the registrant's Common Stock
outstanding.
INDEX
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
Page
PART I. FINANCIAL INFORMATION Number
- ------------------------------ -------
Item 1. Financial Statements
Consolidated Balance Sheets 3
Consolidated Income Statements 4
Consolidated Statements of Cash Flows 5
Consolidated Statements of Shareholders' Equity 6
Notes to Consolidated Financial Statements 7-20
Item 2. Management's Discussion and Analysis of Financial Condition 21-32
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 33
Item 4. Controls and Procedures 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 34-35
Item 6. Exhibits and Reports on Form 8-K 36
SIGNATURES 37
EXHIBITS
PART 1. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
May 29, February 28,
2004 2004
----------- -----------
(Dollars in thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 60,241 $ 129,339
Investment securities available-for-sale 12,145 221,850
Trade accounts receivable, net 130,431 118,902
Sales-type lease receivables 8,201 7,705
Inventories 97,368 76,784
Deferred income taxes 32,314 34,396
Other current assets 29,886 24,426
----------- -----------
TOTAL CURRENT ASSETS 370,586 613,402
SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS, net 620,700 591,362
GOODWILL, net 312,676 188,612
PROPERTY, PLANT AND EQUIPMENT, net 63,634 57,576
INTANGIBLE ASSETS, net 97,562 28,231
REFUNDABLE PERFORMANCE DEPOSIT 20,000 20,000
SALES-TYPE LEASE RECEIVABLES 15,801 17,653
OTHER ASSETS 38,540 42,295
----------- -----------
TOTAL ASSETS $ 1,539,499 $ 1,559,131
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 75,808 $ 80,004
Accrued expenses 49,465 47,428
Employee compensation 21,963 33,981
Advance payments from customers 127,238 104,128
Deferred revenue and advance billings 30,628 14,459
Income taxes payable 21,395 12,394
Taxes other than income taxes 20,171 19,459
Current portion of long-term debt 5,816 106,319
----------- -----------
TOTAL CURRENT LIABILITIES 352,484 418,172
LONG-TERM DEBT, less current portion 453,463 463,215
OTHER LIABILITIES 55,898 53,736
DEFERRED INCOME TAXES 89,443 61,719
COMMITMENTS AND CONTINGENCIES - -
SHAREHOLDERS' EQUITY:
Preferred Stock, par value $.01 per share - 20,000,000 shares authorized, none issued - -
Common Stock, par value $.01 per share - 150,000,000 shares authorized,
92,295,404 and 92,295,404 shares issued; 58,993,004 and 59,197,584 shares
outstanding at May 29, 2004 and February 28, 2004, respectively 923 923
Additional paid-in capital 271,570 266,320
Accumulated other comprehensive loss (71,836) (70,508)
Retained earnings 884,700 839,270
----------- -----------
1,085,357 1,036,005
Less cost of 33,302,400 and 33,097,820 shares in treasury at
May 29, 2004 and February 28, 2004, respectively (497,146) (473,716)
----------- -----------
588,211 562,289
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,539,499 $ 1,559,131
=========== ===========
See Notes to Consolidated Financial Statements
-3-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS
(Unaudited)
Three Months Ended
-------------------------
May 29, May 24,
2004 2003
---------- -----------
(Dollars in thousands,
except per share amounts)
Revenues:
Services $ 253,326 $ 223,538
Sales of products 26,879 16,047
---------- -----------
280,205 239,585
Costs and expenses:
Costs of services 147,293 126,797
Costs of sales 15,917 8,629
---------- -----------
163,210 135,426
---------- -----------
Gross profit 116,995 104,159
Selling, general and administrative 27,635 24,280
Research and development 13,087 14,390
---------- -----------
Operating expenses 40,722 38,670
---------- -----------
Operating income 76,273 65,489
Other income (expense):
Interest income 1,335 1,188
Equity in earnings of unconsolidated affiliates 1,306 1,929
Other income (expense) 10,525 (1,180)
Interest expense (4,336) (2,306)
---------- -----------
8,830 (369)
---------- -----------
Income before income taxes 85,103 65,120
Income taxes 31,488 24,094
---------- -----------
Net income $ 53,615 $ 41,026
========== ===========
Basic earnings per share $ 0.90 $ 0.72
========== ===========
Diluted earnings per share $ 0.80 $ 0.68
========== ===========
Weighted average shares outstanding - basic 59,312 56,904
========== ===========
Weighted average shares outstanding - diluted 67,489 60,228
========== ===========
Dividends per share - common stock $ 0.17 $ -
========== ===========
See Notes to Consolidated Financial Statements
-4-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
----------------------
May 29, May 24,
2004 2003
--------- ---------
(Dollars in thousands)
OPERATING ACTIVITIES
Net income $ 53,615 $ 41,026
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation 33,379 25,692
Intangibles amortization 1,633 447
Deferred income taxes benefit 7,237 -
Tax benefit related to stock award plans 5,250 4,415
Net charge associated with the early retirement of debt 751 -
Gain on sale of investment (10,924) -
Equity in earnings of unconsolidated affiliates, net of dividends received (494) (959)
Other 2,725 3,284
Changes in operating assets and liabilities:
Trade accounts receivable (6,417) 11,447
Inventories (10,340) (12,426)
Accounts payable (7,020) (2,049)
Employee compensation (13,802) (17,438)
Advance payments from customers 22,610 10,941
Deferred revenue and advance billings 16,169 2,920
Income taxes payable 9,899 (2,799)
Other assets and liabilities (7,823) (1,532)
--------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES 96,448 62,969
INVESTING ACTIVITIES
Acquisitions (net of cash acquired) (193,018) -
Purchases of systems, equipment and other assets relating to contracts (53,932) (58,663)
Purchases of available-for-sale investment securities (49,895) -
Maturities and sales of available-for-sale investment securities 259,600 -
Proceeds from sale of investment 11,773 -
Other (2,748) (1,186)
--------- ---------
NET CASH USED FOR INVESTING ACTIVITIES (28,220) (59,849)
FINANCING ACTIVITIES
Net proceeds from issuance of long-term debt - 1,409
Principal payments on long-term debt (91,239) (866)
Purchases of treasury stock (28,275) -
Redemption premium paid in connection with the early retirement of debt (10,610) -
Dividends paid (10,103) -
Proceeds from stock options 3,508 8,406
Other 769 (52)
--------- ---------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (135,950) 8,897
Effect of exchange rate changes on cash (1,376) 3,285
--------- ---------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (69,098) 15,302
Cash and cash equivalents at beginning of period 129,339 116,174
--------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 60,241 $ 131,476
========= =========
See Notes to Consolidated Financial Statements
-5-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - (Unaudited)
Accumulated
Additional Other
Outstanding Common Paid-in Comprehensive Retained
Shares Stock Capital Loss Earnings
----------- ----------- ----------- ----------- ------------
(Dollars in thousands)
Balance at February 28, 2004 59,197,584 $ 923 $ 266,320 $ (70,508) $ 839,270
Comprehensive income:
Net income - - - - 53,615
Other comprehensive income (loss), net of tax:
Foreign currency translation - - - (2,220) -
Unrecognized net gain on derivative instruments - - - 894 -
Unrealized loss on investments - - - (2) -
Comprehensive income
Treasury shares purchased (545,000) - - - -
Cash dividends on common stock ($0.17 per share) - - - - (10,176)
Shares issued under employee stock purchase
and stock award plans 113,595 - - - 1,711
Shares issued upon exercise of stock options 226,825 - - - 280
Tax benefits related to stock award plans - - 5,250 - -
----------- ----------- ----------- ----------- -----------
Balance at May 29, 2004 58,993,004 $ 923 $ 271,570 $ (71,836) $ 884,700
=========== =========== =========== =========== ===========
Treasury
Stock Total
----------- -----------
Balance at February 28, 2004 $ (473,716) $ 562,289
Comprehensive income:
Net income - 53,615
Other comprehensive income (loss), net of tax:
Foreign currency translation - (2,220)
Unrecognized net gain on derivative instruments - 894
Unrealized loss on investments - (2)
-----------
Comprehensive income 52,287
Treasury shares purchased (28,275) (28,275)
Cash dividends on common stock ($0.17 per share) - (10,176)
Shares issued under employee stock purchase
and stock award plans 1,617 3,328
Shares issued upon exercise of stock options 3,228 3,508
Tax benefits related to stock award plans - 5,250
----------- -----------
Balance at May 29, 2004 $ (497,146) $ 588,211
=========== ===========
See Notes to Consolidated Financial Statements
-6-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
NOTE 1- ORGANIZATION, BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION
PLANS
ORGANIZATION
GTECH Holdings Corporation ("Holdings") is a global technology services company
providing software, networks and professional services that power
high-performance solutions. We are the world's leading operator of highly-secure
online lottery transaction processing systems, doing business in 45 countries
worldwide and we have a growing presence in commercial gaming technology and
financial services transaction processing. We have a single operating and
reportable business segment, the Transaction Processing segment. In these notes,
the terms "Holdings," "Company," "we," "our," and "us" refer to GTECH Holdings
Corporation and all subsidiaries included in the consolidated financial
statements, unless otherwise specified. The accounting policies of the
Transaction Processing segment are the same as those described in Note 1 -
"Organization and Summary of Significant Accounting Policies" in our
Consolidated Financial Statements and footnotes included in our fiscal 2004
Annual Report on Form 10-K. Management evaluates the performance of this segment
based on operating income.
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Holdings, the
parent of GTECH Corporation ("GTECH"), have been prepared in accordance with
generally accepted accounting principles ("GAAP") for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. They do not include all information and notes required by GAAP for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three-month period ended May 29, 2004
are not necessarily indicative of the results that may be expected for the full
fiscal year ending February 26, 2005. The balance sheet at February 28, 2004 has
been derived from the audited financial statements at that date. For further
information refer to the Consolidated Financial Statements and footnotes
included in our fiscal 2004 Annual Report on Form 10-K.
Certain amounts in our prior period financial statements have been reclassified
to conform to the current period presentation.
Our Consolidated Statements of Cash Flows presents the $10.6 million redemption
premium we paid in connection with the early retirement of debt as a financing
activity. Our Form 8-K filing on June 22, 2004 (incorporating by reference a
press release we issued on June 22, 2004 announcing our fiscal 2005 first
quarter results) included a consolidated statement of cash flows presenting
this redemption premium as an operating activity.
STOCK-BASED COMPENSATION PLANS
We follow Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related Interpretations in accounting for our
stock-based compensation plans and we have elected to continue to use the
intrinsic value-based method to account for stock option grants. We have adopted
the disclosure-only provisions of Statement of Financial Accounting Standards
No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure,"
an amendment of Statement of Financial Accounting Standards No. 123.
Accordingly, no compensation expense has been recognized for our stock-based
compensation plans other than for restricted stock.
-7-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 1 - ORGANIZATION, BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION PLANS
(continued)
Had we elected to recognize compensation expense based upon the fair value at
the grant dates for awards under these plans, net income and earnings per share
would have been reduced to the pro forma amounts listed in the table below. The
fair value of each grant is estimated on the date of grant using the
Black-Scholes option pricing model.
Three Months Ended
------------------------------------------
May 29, May 24,
2004 2003
------------------ -----------------
(Dollars in thousands,
except per share amounts)
Net income, as reported $ 53,615 $ 41,026
Add: Stock-based compensation expense included in reported
net income, net of related tax effects 598 420
Deduct: Total stock-based compensation expense determined under
the fair value method for all awards, net of related tax effects (2,012) (1,897)
------------------ -----------------
Pro forma net income $ 52,201 $ 39,549
================== =================
Basic earnings per share:
As reported $ .90 $ .72
Pro forma .88 .70
Diluted earnings per share:
As reported $ .80 $ .68
Pro forma .78 .66
NOTE 2 - BUSINESS ACQUISITIONS
SPIELO MANUFACTURING INCORPORATED
On April 30, 2004, we completed the acquisition of privately-held Spielo
Manufacturing Incorporated ("Spielo"), a leading provider of video lottery
terminals ("VLT's") and related products and services to the global gaming
industry, for an all-cash purchase price of approximately $150 million. In
addition, we paid Spielo shareholders approximately $7 million out of a
potential maximum earn-out amount of up to $35 million, which Spielo
shareholders are entitled to receive in the 18 months following the closing,
based upon Spielo achieving certain VLT installation objectives in New York.
Approval of this transaction by our shareholders was not required.
LEEWARD ISLANDS LOTTERY HOLDING COMPANY INC.
On May 5, 2004, we completed the acquisition of privately-held Leeward Islands
Lottery Holding Company Inc. ("LILHCo"), a lottery operating company
headquartered on the Caribbean islands of Antigua and St. Croix, for an all-cash
purchase price of approximately $40 million. Approval of this transaction by our
shareholders was not required.
We have not finalized the evaluation and allocation of the purchase price for
the Spielo and LILHCo acquisitions as the appraisals associated with the
valuation of certain tangible and intangible assets are not yet complete. We do
not believe the appraisals will materially modify the preliminary purchase price
allocations.
These acquisitions are individually and in the aggregate, not material to our
consolidated financial statements and accordingly, pro forma financial
information has not been presented.
-8-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 3 - INVENTORIES
May 29, February 28,
2004 2004
------------------ -----------------
(Dollars in thousands)
Inventories consist of:
Raw materials $ 23,437 $ 14,540
Work in progress 70,530 60,470
Finished goods 3,401 1,774
------------------ -----------------
$ 97,368 $ 76,784
================== =================
Inventories include amounts we manufacture or assemble for our long-term service
contracts and amounts related to product sales contracts, including product
sales which are accounted for using contract accounting. Work in progress at May
29, 2004 and February 28, 2004, includes approximately $65.4 million and $54.9
million, respectively, related to product sale contracts.
Amounts received from customers in advance of revenue recognition (primarily
related to product sale contracts included in work in progress above) totaled
$127.2 million and $104.1 million at May 29, 2004 and February 28, 2004,
respectively.
NOTE 4 - PRODUCT WARRANTIES
We offer a product warranty on all of our manufactured products (primarily
terminals and related peripherals) sold to our customers. Although we do not
have a standard product warranty, our typical warranty provides that we will
repair or replace defective products for a period of time (usually a minimum of
90 days) from the date revenue is recognized or from the date a product is
delivered and tested. We estimate product warranty costs that we expect to incur
during the warranty period and we record a charge to costs of sales for the
estimated warranty cost at the time the product sale is recorded. In determining
the appropriate warranty provision, consideration is given to historical
warranty cost information, the status of the terminal model in its life cycle
and current terminal performance. We periodically assess the adequacy of our
product warranty reserves and adjust them as necessary in the period when the
information necessary to make the adjustment becomes available.
We typically do not provide a product warranty on purchased products sold to our
customers but attempt to pass the manufacturer's warranty, if any, on to them.
A summary of product warranty activity, which is included in Accrued Expenses in
our Consolidated Balance Sheets, is as follows (dollars in thousands):
Balance at February 28, 2004 $ 749
Opening reserve balance associated with acquisitions 1,126
Additional reserves 81
Charges incurred (151)
Change in estimate (300)
------------------
Balance at May 29, 2004 $ 1,505
==================
-9-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 5 - LONG-TERM DEBT
May 29, February 28,
2004 2004
------------------ -----------------
(Dollars in thousands)
Long-term debt consists of:
4.75% Senior Notes due October 2010 $ 249,650 $ 249,636
1.75% Convertible Debentures due December 2021 175,000 175,000
World Headquarters loan due January 2007 27,933 27,933
Deferred interest rate swap gains due through October 2010 1,272 12,009
Fair value of interest rate swaps (3,800) 4,893
7.87% Series B Guaranteed Senior Notes due May 2007 - 90,000
Other, due through April 2006 9,224 10,063
------------------ -----------------
459,279 569,534
Less current portion 5,816 106,319
------------------ -----------------
$ 453,463 $ 463,215
================== =================
We have a $300 million unsecured revolving credit facility expiring in June 2006
(the "Credit Facility"). There were no outstanding borrowings under the Credit
Facility at May 29, 2004 or February 28, 2004. Up to $100 million of the Credit
Facility may be used for the issuance of letters of credit. At May 29, 2004,
there was $291.5 million available for borrowing under the Credit Facility,
after considering $8.5 million of letters of credit issued and outstanding.
In May 2004, GTECH repurchased the remaining $90.0 million of its 7.87% Series B
Guaranteed Senior Notes due May 2007 (the "2007 Senior Notes"). The 2007 Senior
Notes were unsecured and unsubordinated obligations of GTECH that were fully and
unconditionally guaranteed by Holdings and certain of its subsidiaries. Interest
was payable semi-annually in arrears on May 15 and November 15 of each year. In
connection with this repurchase, we incurred a net charge of $0.8 million,
principally comprised of a redemption premium net of deferred interest rate swap
gains which was recorded in Other Income (Expense) in our Consolidated Income
Statements.
Holders of our 1.75% Convertible Debentures due December 2021 ("Debentures") may
require us to repurchase all or part of their Debentures on December 15, 2004,
December 15, 2006, December 15, 2011 and December 15, 2016 at a price equal to
100% of the principal amount of the Debentures, plus accrued interest. We have
classified the Debentures as long-term liabilities in our Consolidated Balance
Sheets at May 29, 2004 and February 28, 2004 because we intend to borrow under
our $300 million Credit Facility to refinance any amount holders of the
Debentures require us to repurchase on December 15, 2004. Any amount borrowed
under the Credit Facility is expected to remain outstanding for an uninterrupted
period extending beyond one year from May 29, 2004.
NOTE 6 - COMMITMENTS AND CONTINGENCIES
See "Legal Proceedings" in Part II, Item 1 and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Part I, Item 2 of
this report.
-10-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 7 - GUARANTEES AND INDEMNIFICATIONS
PERFORMANCE AND OTHER BONDS
In connection with certain contracts and procurements, we have been required to
deliver performance bonds for the benefit of our customers and bid and
litigation bonds for the benefit of potential customers, respectively. These
bonds give the beneficiary the right to obtain payment and/or performance from
the issuer of the bond if the events set forth in the bond occur. In the case of
performance bonds, which generally have a term of one year, such events include
our failure to perform our obligations under the applicable contract. To obtain
these bonds, we are required to indemnify the issuers against the costs they
incur if a beneficiary exercises its rights under a bond. Historically, our
customers have not exercised their rights under these bonds and we do not
currently anticipate that they will do so. The following table provides
information related to potential commitments at May 29, 2004:
Total potential
commitments
---------------
(in thousands)
Performance bonds $ 214,528
Litigation bonds 8,138
Financial guarantees 4,609
All other bonds 2,137
---------------
$ 229,412
===============
LOTTERY TECHNOLOGY SERVICES INVESTMENT CORPORATION
We have a 44% interest in Lottery Technology Services Investment Corporation
("LTSIC"), which we account for using the equity method of accounting. LTSIC's
wholly owned subsidiary, Lottery Technology Services Corporation ("LTSC"),
provides equipment and services (which we supplied to LTSC), to the Bank of
Taipei. The Bank of Taipei holds the license to operate the Taiwan Public
Welfare Lottery.
In fiscal 2002, in order to assist LTSC with the financing they required to
enable them to perform under their obligation to operate the Taiwan Public
Welfare Lottery on behalf of the Bank of Taipei, we guaranteed loans made to
LTSC by an unrelated commercial lender. The loans have a maturity date of March
2007 and our guarantee expires in July 2007. We did not receive any
consideration in exchange for our guarantees on behalf of LTSC. Rather, these
guarantees were issued in connection with the formation of LTSC and LTSIC. At
May 29, 2004, the principal amount of the loans was $5.3 million and our
guarantee was $2.3 million.
We are recognizing 56% of our product sales to, and service revenue from, LTSC.
The remaining 44% of product sales (and related cost) and service revenue, has
been deferred as a result of our equity interest in LTSIC and related guarantee
of LTSC's debt, respectively, and is included in Deferred Revenue and Advance
Billings and Other Liabilities in our Consolidated Balance Sheets at May 29,
2004 and February 28, 2004. Product sale deferrals are being recognized ratably
over the life of our contract with LTSC and service revenue deferrals are being
recognized as the guaranteed debt is repaid. At May 29, 2004, deferred product
gross profit and deferred service revenue totaled $3.2 million and $2.3 million,
respectively.
-11-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 7 - GUARANTEES AND INDEMNIFICATIONS (continued)
TIMES SQUARED INCORPORATED
We guaranteed outstanding lease obligations of Times Squared Incorporated
("Times Squared") for which we received no monetary consideration. The amount
outstanding under the lease at May 29, 2004, was $2.3 million. Our guarantee
expires in December 2013. Times Squared is a nonprofit corporation established
to provide, among other things, secondary and high school level educational
programs. Times Squared operates a Charter School for Engineering, Mathematics,
Science and Technology in Providence, Rhode Island that serves inner city
children who aspire to careers in the sciences and technology.
LOTTERY TECHNOLOGY ENTERPRISES
We have a 1% interest in Lottery Technology Enterprises ("LTE"), a joint venture
between us and District Enterprise for Lottery Technology Applications of
Washington, D.C. The joint venture agreement terminates on December 31, 2012.
LTE holds a 10-year contract (which expires in November 2009) with the District
of Columbia Lottery and Charitable Games Control Board. Under Washington, D.C.
law, by virtue of our 1% interest in LTE, we are jointly and severally liable,
with the other partner, for the acts of the joint venture.
NOTE 8 -- COMPREHENSIVE INCOME
The components of comprehensive income are as follows:
Three Months Ended
-------------------------------------
May 29, May 24,
2004 2003
------------------ -----------------
(Dollars in thousands)
Net income $ 53,615 $ 41,026
Other comprehensive income (loss), net of tax
Foreign currency translation (2,220) 9,217
Unrecognized net gain (loss) on derivative instruments 894 (5,048)
Unrealized loss on investments (2) -
------------------ -----------------
Comprehensive income $ 52,287 $ 45,195
================== =================
NOTE 9 - SALE OF INVESTMENT
At February 28, 2004, we held a 50% interest in Gaming Entertainment (Delaware)
L.L.C. ("GED"), an entity that manages a racino for Harrington Raceway, Inc.
("Harrington"). On April 9, 2004, we sold our 50% interest in GED to Harrington
for $11.8 million and recognized a gain of $10.9 million which was recorded in
Other Income (Expense) in our Consolidated Income Statements.
-12-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 10 - EARNINGS PER SHARE
The following table shows the computation of basic and diluted earnings per
share:
Three Months Ended
-------------------------------------
May 29, May 24,
2004 2003
------------------ -----------------
(Dollars and shares in thousands,
except per share amounts)
Numerator:
Net income (Numerator for basic earnings per share) $ 53,615 $ 41,026
Effect of dilutive securities:
Interest expense on 1.75% Convertible Debentures, net of tax 529 142
------------------ -----------------
Numerator for diluted earnings per share $ 54,144 $ 41,168
================== =================
Denominator:
Denominator for basic earnings per share - weighted-average shares 59,312 56,904
Effect of dilutive securities:
1.75% Convertible Debentures 6,364 1,690
Employee stock options 1,690 1,567
Unvested restricted and stock bonus discount shares 123 67
------------------ -----------------
Dilutive potential common shares 8,177 3,324
Denominator for diluted earnings per share - adjusted
weighted-average shares and assumed conversions 67,489 60,228
================== =================
Basic earnings per share $ .90 $ .72
================== =================
Diluted earnings per share $ .80 $ .68
================== =================
Our 1.75% Convertible Debentures ("Debentures") are convertible at the option of
the holder into shares of our common stock at an initial conversion rate of
36.3636 shares of common stock per $1,000 principal amount of Debentures, which
is equivalent to an initial conversion price of approximately $27.50 per share.
The Debentures become convertible when, among other circumstances, the closing
price of our common stock is more than 120% of the conversion price
(approximately $33 per share) for at least 20 out of 30 consecutive trading days
prior to the date of surrender for conversion. There are a total of 6.4 million
shares issuable upon the conversion of the Debentures.
The Debentures were convertible for all 64 trading days in the quarter ended May
29, 2004, and all 6.4 million shares were included in the computation of diluted
earnings per share. For the quarter ended May 24, 2003, the debentures were
convertible for 17 out of 64 trading days resulting in 1.7 million of the 6.4
million shares included in the computation of diluted earnings per share.
-13-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 11 - INCOME TAXES
Our effective income tax rate is greater than the statutory rate primarily due
to state income taxes. The effective income tax rate is based upon expected
income for the year, the composition of income or loss in different
jurisdictions and related statutory tax rates, accruals for tax contingencies
and the tax consequences or benefits from audits or the resolution of tax
contingencies.
NOTE 12 - SUBSEQUENT EVENT
On June 17, 2004, our Board of Directors approved a 2-for-1 common stock split,
payable in the form of a stock dividend, which entitles each shareholder of
record on July 1, 2004 to receive one share of common stock for each outstanding
share of common stock held on that date. The stock dividend will be distributed
on July 30, 2004. All references to common shares and per share amounts herein
are presented on a pre-split basis.
A June 25, 2004 ruling in a civil action initiated by federal attorneys with
Brazil's Public Ministry will have the effect of materially reducing payments
that we otherwise would receive over the remaining term of our lottery contract
with Caixa Economica Federal ("CEF"), our customer and the operator of Brazil's
National Lottery, which expires in May 2005. This ruling has ordered that 30%
of payments subsequent to the June 25, 2004 ruling due to GTECH Brasil Ltda.,
our Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited
in an account maintained by the Court (as further discussed in "Legal
Proceedings - Brazilian Legal Proceedings" in Part II, Item 1 in this report).
Accordingly, we will not recognize service revenues for the payments that are
withheld from GTECH Brazil, as realization of these amounts is not reasonably
assured. In addition, the ruling ordered that all assets of GTECH Brazil be
identified to the Court so as to prevent their transfer or disposition. As of
May 29, 2004, GTECH Brazil assets approximated $25.0 million.
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
On December 18, 2001, Holdings (the "Parent Company") issued, in a private
placement, $175 million principal amount of 1.75% Convertible Debentures due
December 15, 2021 (the "Debentures"). On October 9, 2003, the Parent Company
issued, in a private placement, $250 million principal amount of 4.75% Senior
Notes due October 15, 2010, all of which were subsequently exchanged for 4.75%
Senior Notes due October 15, 2010 registered under the Securities Act of 1933
(the "Senior Notes"). The Debentures and Senior Notes are unsecured and
unsubordinated obligations of the Parent Company that are jointly and severally,
fully and unconditionally guaranteed by GTECH and two of its wholly owned
subsidiaries: GTECH Rhode Island Corporation and GTECH Latin America Corporation
(collectively with GTECH, the "Guarantor Subsidiaries"). Condensed consolidating
financial information is presented below.
Selling, general and administrative costs and research and development costs are
allocated to each subsidiary based on the ratio of the subsidiaries' combined
service revenues and sales of products to consolidated revenues.
The Parent Company conducts business through its consolidated subsidiaries and
unconsolidated affiliates and has, as its only material asset, an investment in
GTECH. Equity in earnings of consolidated affiliates recorded by the Parent
Company includes the Parent Company's share of the after-tax earnings of GTECH.
Taxes payable and deferred income taxes are obligations of the subsidiaries.
Income tax expense related to both current and deferred income taxes are
allocated to each subsidiary based on our consolidated effective income tax
rates.
-14-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Balance Sheets
May 29, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
--------------- ------------- --------------- ------------- --------------
(Dollars in thousands)
Assets
Current Assets:
Cash and cash equivalents $ - $ 15,804 $ 44,437 $ - $ 60,241
Investment securities
available-for-sale - 12,145 - - 12,145
Trade accounts receivable, net - 69,728 60,703 - 130,431
Due from subsidiaries and affiliates - 46,143 - (46,143) -
Sales-type lease receivables - 3,857 4,344 - 8,201
Inventories - 53,338 49,913 (5,883) 97,368
Deferred income taxes - 27,246 5,068 - 32,314
Other current assets - 11,814 18,072 - 29,886
--------------- ------------- --------------- ------------- --------------
Total Current Assets - 240,075 182,537 (52,026) 370,586
Systems, Equipment and Other
Assets Relating to Contracts, net - 536,218 92,845 (8,363) 620,700
Investment in Subsidiaries and
Affiliates 588,211 353,110 - (941,321) -
Goodwill, net - 116,345 196,331 - 312,676
Property, Plant and Equipment, net - 28,292 35,342 - 63,634
Intangible Assets, net - 21,255 76,307 - 97,562
Refundable Performance Deposit - - 20,000 - 20,000
Sales-Type Lease Receivables - 7,020 8,781 - 15,801
Other Assets - 14,143 24,397 - 38,540
--------------- ------------- --------------- ------------- --------------
Total Assets $ 588,211 $ 1,316,458 $ 636,540 $ (1,001,710) $ 1,539,499
=============== ============= =============== ============== ==============
Liabilities and Shareholders' Equity
Current Liabilities:
Accounts payable $ - $ 36,966 $ 38,842 $ - $ 75,808
Due to subsidiaries and affiliates - - 46,143 (46,143) -
Accrued expenses - 26,228 23,237 - 49,465
Employee compensation - 14,972 6,991 - 21,963
Advance payments from customers - 68,937 58,301 - 127,238
Deferred revenue and advance
billings - 19,811 10,817 - 30,628
Income taxes payable - 15,361 6,034 - 21,395
Taxes other than income taxes - 9,513 10,658 - 20,171
Current portion of long-term debt - 198 5,618 - 5,816
--------------- ------------- --------------- ------------- --------------
Total Current Liabilities - 191,986 206,641 (46,143) 352,484
Long-Term Debt, less current
portion - 421,923 31,540 - 453,463
Other Liabilities - 39,500 16,398 - 55,898
Deferred Income Taxes - 60,592 28,851 - 89,443
Shareholders' Equity 588,211 602,457 353,110 (955,567) 588,211
--------------- ------------- --------------- -------------- --------------
Total Liabilities and
Shareholders' Equity $ 588,211 $ 1,316,458 $ 636,540 $ (1,001,710) $ 1,539,499
=============== ============= =============== ============== ==============
-15-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Balance Sheets
February 28, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
--------------- ------------- --------------- ------------- --------------
(Dollars in thousands)
Assets
Current Assets:
Cash and cash equivalents $ - $ 68,956 $ 60,383 $ - $ 129,339
Investment securities
available-for-sale - 221,850 - - 221,850
Trade accounts receivable, net - 75,590 43,312 - 118,902
Due from subsidiaries and affiliates - 49,168 - (49,168) -
Sales-type lease receivables - 3,967 3,738 - 7,705
Inventories - 52,697 29,943 (5,856) 76,784
Deferred income taxes - 30,254 4,142 - 34,396
Other current assets - 5,481 18,945 - 24,426
--------------- ------------- --------------- ------------- --------------
Total Current Assets - 507,963 160,463 (55,024) 613,402
Systems, Equipment and Other
Assets Relating to Contracts, net - 518,976 80,111 (7,725) 591,362
Investment in Subsidiaries and
Affiliates 562,289 162,788 - (725,077) -
Goodwill, net - 115,965 72,647 - 188,612
Property, Plant and Equipment, net - 28,543 29,033 - 57,576
Intangible Assets, net - 21,850 6,381 - 28,231
Refundable Performance Deposit - - 20,000 - 20,000
Sales-Type Lease Receivables - 8,125 9,528 - 17,653
Other Assets - 20,822 21,473 - 42,295
--------------- ------------- --------------- ------------- --------------
Total Assets $ 562,289 $ 1,385,032 $ 399,636 $ (787,826) $ 1,559,131
=============== ============= =============== ============== ==============
Liabilities and Shareholders' Equity
Current Liabilities:
Accounts payable $ - $ 54,967 $ 25,037 $ - $ 80,004
Due to subsidiaries and affiliates - - 49,168 (49,168) -
Accrued expenses - 32,041 15,387 - 47,428
Employee compensation - 29,256 4,725 - 33,981
Advance payments from customers - 45,648 58,480 - 104,128
Deferred revenue and advance
billings - 8,282 6,177 - 14,459
Income taxes payable - 4,419 7,975 - 12,394
Taxes other than income taxes - 8,643 10,816 - 19,459
Current portion of long-term debt - 100,886 5,433 - 106,319
--------------- ------------- --------------- -------------- --------------
Total Current Liabilities - 284,142 183,198 (49,168) 418,172
Long-Term Debt, less current
portion - 430,652 32,563 - 463,215
Other Liabilities - 36,526 17,210 - 53,736
Deferred Income Taxes - 57,842 3,877 - 61,719
Shareholders' Equity 562,289 575,870 162,788 (738,658) 562,289
--------------- ------------- --------------- -------------- --------------
Total Liabilities and
Shareholders' Equity $ 562,289 $ 1,385,032 $ 399,636 $ (787,826) $ 1,559,131
=============== ============= =============== ============== ==============
-16-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Income Statements
Three Months Ended May 29, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
--------------- ------------- --------------- -------------- --------------
(Dollars in thousands)
Revenues:
Services $ - $ 178,663 $ 74,663 $ - $ 253,326
Sales of products - 18,444 8,435 - 26,879
Intercompany sales and fees - 31,906 14,191 (46,097) -
--------------- ------------- --------------- -------------- --------------
- 229,013 97,289 (46,097) 280,205
Costs and expenses:
Costs of services - 104,074 43,737 (518) 147,293
Costs of sales - 11,368 4,562 (13) 15,917
Intercompany cost of sales
and fees - 23,696 4,291 (27,987) -
--------------- ------------- --------------- -------------- --------------
- 139,138 52,590 (28,518) 163,210
--------------- ------------- --------------- -------------- --------------
Gross profit - 89,875 44,699 (17,579) 116,995
Selling, general & administrative - 19,442 8,193 - 27,635
Research and development - 9,206 3,881 - 13,087
--------------- ------------- --------------- ------------- --------------
Operating expenses - 28,648 12,074 - 40,722
--------------- ------------- --------------- ------------- --------------
Operating income - 61,227 32,625 (17,579) 76,273
Other income (expense):
Interest income - 613 722 - 1,335
Equity in earnings of
unconsolidated affiliates - 1,341 (35) - 1,306
Equity in earnings of
consolidated affiliates 53,615 28,241 - (81,856) -
Other income (expense) - (1,429) 11,954 - 10,525
Interest expense - (3,897) (439) - (4,336)
--------------- ------------- --------------- ------------- --------------
Income before income taxes 53,615 86,096 44,827 (99,435) 85,103
Income taxes - 31,856 16,586 (16,954) 31,488
--------------- ------------- --------------- -------------- --------------
Net income $ 53,615 $ 54,240 $ 28,241 $ (82,481) $ 53,615
=============== ============= =============== ============= ==============
-17-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
(continued)
Condensed Consolidating Income Statements
Three Months Ended May 24, 2003
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
--------------- ------------- --------------- -------------- --------------
(Dollars in thousands)
Revenues:
Services $ - $ 166,303 $ 57,235 $ - $ 223,538
Sales of products - 11,616 4,431 - 16,047
Intercompany sales and fees - 26,847 10,305 (37,152) -
--------------- ------------- --------------- ------------- --------------
- 204,766 71,971 (37,152) 239,585
Costs and expenses:
Costs of services - 90,021 37,822 (1,046) 126,797
Costs of sales - 6,287 2,362 (20) 8,629
Intercompany cost of sales
and fees - 15,970 4,646 (20,616) -
--------------- ------------- --------------- ------------- --------------
- 112,278 44,830 (21,682) 135,426
--------------- ------------- --------------- ------------- --------------
Gross profit - 92,488 27,141 (15,470) 104,159
Selling, general & administrative - 18,033 6,247 - 24,280
Research and development - 10,684 3,706 - 14,390
--------------- ------------- --------------- ------------- --------------
Operating expenses - 28,717 9,953 - 38,670
--------------- ------------- --------------- ------------- --------------
Operating income - 63,771 17,188 (15,470) 65,489
Other income (expense):
Interest income - 359 829 - 1,188
Equity in earnings of
unconsolidated affiliates - 1,190 739 - 1,929
Equity in earnings of
consolidated affiliates 41,026 9,478 - (50,504) -
Other income (expense) - 2,018 (3,198) - (1,180)
Interest expense - (1,793) (513) - (2,306)
--------------- ------------- --------------- ------------- --------------
Income before income taxes 41,026 75,023 15,045 (65,974) 65,120
Income taxes - 27,759 5,567 (9,232) 24,094
--------------- ------------- --------------- ------------- --------------
Net income $ 41,026 $ 47,264 $ 9,478 $ (56,742) $ 41,026
=============== ============= =============== ============= ==============
-18-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION(continued)
Condensed Consolidating Statements of Cash Flows
Three Months Ended May 29, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------- ------------- --------------- ------------- --------------
(Dollars in thousands)
Net cash provided by operating
activities $ - $ 88,705 $ 8,064 $ (321) $ 96,448
Investing Activities
Acquisitions (net of cash acquired) - - (193,018) - (193,018)
Purchases of systems, equipment
and other assets relating to
contracts - (46,887) (7,366) 321 (53,932)
Purchases of available-for-sale
investment securities - (49,895) - - (49,895)
Maturities and sales of
available-for-sale investment
securities - 259,600 - - 259,600
Proceeds from sale of investment - - 11,773 - 11,773
Other - (1,957) (791) - (2,748)
------------- ------------- --------------- ------------- --------------
Net cash provided by (used for)
investing activities - 160,861 (189,402) 321 (28,220)
Financing Activities
Principal payments on long-term
debt - (90,000) (1,239) - (91,239)
Purchases of treasury stock (28,275) - - - (28,275)
Redemption premium paid in
connection with the early
retirement of debt - (10,610) - - (10,610)
Dividends paid (10,103) - - - (10,103)
Proceeds from stock options 3,508 - - - 3,508
Intercompany capital transactions 34,055 (202,055) 168,000 - -
Other 815 (46) - - 769
------------- ------------- --------------- ------------- --------------
Net cash provided by (used for)
financing activities - (302,711) 166,761 - (135,950)
Effect of exchange rate changes
on cash - (7) (1,369) - (1,376)
------------- ------------- --------------- ------------- --------------
Decrease in cash and
cash equivalents - (53,152) (15,946) - (69,098)
Cash and cash equivalents at
beginning of period - 68,956 60,383 - 129,339
------------- ------------- --------------- ------------- --------------
Cash and cash equivalents at end
of period $ - $ 15,804 $ 44,437 $ - $ 60,241
============= ============= =============== ============= ==============
-19-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Statements of Cash Flows
Three Months Ended May 24, 2003
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
-------------- ------------ -------------- ------------- --------------
(Dollars in thousands)
Net cash provided by operating
activities $ - $ 58,331 $ 4,675 $ (37) $ 62,969
Investing Activities
Purchases of systems, equipment
and other assets relating to
contracts - (56,750) (1,950) 37 (58,663)
Other - (1,186) - - (1,186)
-------------- ------------- --------------- ------------- --------------
Net cash used for investing
activities - (57,936) (1,950) 37 (59,849)
Financing Activities
Net proceeds from issuance
of long-term debt - - 1,409 - 1,409
Principal payments on long-term
debt - - (866) - (866)
Proceeds from stock options 8,406 - - - 8,406
Intercompany capital transactions (8,876) 8,876 - - -
Other 470 - (522) - (52)
-------------- ------------- --------------- ------------- --------------
Net cash provided by financing
activities - 8,876 21 - 8,897
Effect of exchange rate changes
on cash - (5) 3,290 - 3,285
-------------- ------------- --------------- ------------- --------------
Increase in cash and
cash equivalents - 9,266 6,036 - 15,302
Cash and cash equivalents at
beginning of period - 88,739 27,435 - 116,174
-------------- ------------- --------------- ------------- --------------
Cash and cash equivalents at end
of period $ - $ 98,005 $ 33,471 $ - $ 131,476
============== ============= =============== ============= ==============
-20-
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The following Management's Discussion and Analysis ("MD&A") is intended to help
the reader understand the financial results of GTECH Holdings Corporation. MD&A
is provided as a supplement to, and should be read in conjunction with, our
financial statements and the accompanying notes. This overview provides guidance
on the individual sections of MD&A as follows:
- - FORWARD-LOOKING STATEMENTS - cautionary information about forward-looking
statements.
- - OUR BUSINESS - a general description of our business; Brazilian legal
proceedings; acquisitions; and other business developments.
- - OPERATIONS REVIEW - an analysis of our consolidated results of operations
for the three months ended May 29, 2004 and May 24, 2003 presented in our
financial statements. We operate in one business - Transaction Processing,
and we have a single operating and reportable business segment. Therefore,
our discussions are not quantified by segment results.
- - LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION - an analysis of cash
flows, financial position, and potential commitments.
- - FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY - information about
financial risk management; interest rate market risk; equity price risk;
foreign currency exchange rate risk; and our dividend policy.
- - SUBSEQUENT EVENT - information about our common stock split that occurred
subsequent to May 29, 2004.
Unless specified otherwise, we use the terms "Holdings," "the Company," "we,"
"our," and "us" in MD&A to refer to GTECH Holdings Corporation and its
consolidated subsidiaries included in the consolidated financial statements.
FORWARD-LOOKING STATEMENTS
Statements contained in this section and elsewhere in this report which are not
historical statements constitute "forward-looking statements" within the meaning
of Section 27A of the Securities Act and Section 21E of the Securities Exchange
Act of 1934. Generally, the words "believe," "expect," "estimate," "anticipate,"
"will," "may," "could," "plan," "continue" and similar expressions identify
forward-looking statements. Such statements include, without limitation,
statements relating to:
- - the future prospects for and stability of the lottery industry and other
businesses in which we are engaged or expect to be engaged;
- - our future operating and financial performance;
- - our ability to retain existing contracts and to obtain and retain new
contracts; and
- - the results and effects of legal proceedings and investigations.
-21-
These forward-looking statements reflect management's assessment based on
information currently available, but are not guarantees and are subject to risks
and uncertainties that could cause actual results to differ materially from
those contemplated in the forward-looking statements. These risks and
uncertainties include, among other things, the following:
- - government regulations and other actions affecting the online lottery
industry could have a negative effect on our business and sales;
- - we may be subject to adverse determinations in legal proceedings
(including recently announced legal proceedings in Brazil) which could
result in substantial monetary judgments or reputational damage;
- - our lottery operations are dependent upon our continued ability to retain
and extend our existing contracts and win new contracts;
- - slow growth or declines in sales of online lottery goods and services
could lead to lower revenues and cash flows;
- - we derive close to half of our revenues from foreign jurisdictions
(including over ten percent in fiscal 2004 from our Brazilian operations)
and are subject to the economic, political and social instability risks of
doing business in foreign jurisdictions;
- - our results of operations are exposed to foreign currency exchange rate
fluctuations which could result in lower revenues, net income and cash
flows when such results are translated into U.S. dollar accounts;
- - we have a concentrated customer base and the loss of any of our larger
customers (or lower sales from any of these customers) could lead to lower
revenue;
- - our quarterly operating results may fluctuate significantly, including as
a result of variations in the amount and timing of product sales, the
occurrence of large jackpots in lotteries (which increase the amount
wagered and our revenue) and expenses incurred in connection with lottery
start-ups;
- - we operate in a highly competitive environment and increased competition
may cause us to experience lower cash flows or to lose contracts;
- - we are subject to substantial penalties for failure to perform under our
contracts;
- - we may not be able to respond to technological changes or to satisfy
future technology demands of our customers in which case we could fall
behind our competitors;
- - if we are unable to manage potential risks related to acquisitions, our
business and growth prospects could suffer;
- - expansion of the gaming industry faces opposition which could limit our
access to some markets;
- - our business prospects and future success depend upon our ability to
attract and retain qualified employees;
- - our business prospects and future success rely heavily upon the integrity
of our employees and executives and the security of our systems;
- - our dependence on certain suppliers creates a risk of implementation
delays if the supply contract is terminated or breached, and any delays
may result in substantial penalties;
- - our non-lottery ventures, which are an increasingly important aspect of
our business, may fail; and
- - other risks and uncertainties set forth below and elsewhere in this
report, in our fiscal 2004 Form 10-K, and in our subsequent press releases
and Form 10-Q's and other reports and filings with the Securities and
Exchange Commission.
The foregoing list of important factors is not all-inclusive.
-22-
OUR BUSINESS
GENERAL
We operate on a 52-week or 53-week fiscal year ending on the last Saturday in
February and fiscal 2005 is a 52-week year that ends on February 26, 2005.
Fiscal 2004 was a 53-week year and we included the extra week in our fourth
quarter ended February 28, 2004.
We are a global technology services company providing software, networks and
professional services that power high-performance solutions. We are the world's
leading operator of highly-secure online lottery transaction processing systems,
doing business in 45 countries worldwide and we have a growing presence in
commercial gaming technology and financial services transaction processing. In
fiscal 2004, approximately 91% of our consolidated revenues were lottery
related, approximately 7% were derived from commercial services transaction
processing and approximately 2% were derived from gaming solutions.
Comparatively, in fiscal 2003, lottery related revenues, commercial services
transaction processing revenues and gaming solution revenues were approximately
93%, 5% and 2% of our consolidated revenues, respectively.
Being a global business, we derive a substantial portion of our revenue from our
operations outside of the United States. In particular, in fiscal 2004, we
derived 49.4% of our revenues from international operations and 10.2% of our
revenues from our Brazilian operations alone (including 9.7% of our revenues
from Caixa Economica Federal, the operator of Brazil's National Lottery, our
largest customer in fiscal 2004 based on annual revenues). In addition,
substantial portions of our assets, primarily consisting of equipment we use to
operate online lottery systems for our customers, are held outside of the United
States. We are also exposed to more general risks of international operations,
including increased governmental regulation of the online lottery industry in
the markets where we operate; exchange controls or other currency restrictions;
and significant political instability.
We have derived substantially all of our revenues from the rendering of services
and the sale or supply of computerized online lottery systems and components to
government-authorized lotteries. Our service revenues are derived primarily from
lottery service contracts, which are typically at least five years in duration,
and generally provide compensation to us based upon a percentage of a lottery's
gross online and instant ticket sales. These percentages vary depending on the
size of the lottery and the scope of services provided to the lottery. We
primarily derive product sale revenues from the installation of new online
lottery systems, installation of new software and sales of lottery terminals and
equipment in connection with the expansion of existing lottery systems. Our
product margins fluctuate depending on the mix, volume and timing of product
sale contracts. Our product sale revenues from period to period may not be
comparable due to the size and timing of product sale transactions. During
fiscal 2005, we currently anticipate that product sales will be in the range of
$210 million to $220 million.
Our compensation under lottery service contracts is typically based upon a
percentage of a lottery's gross online and instant ticket sales. Over the past
several fiscal years, we have experienced and may continue to experience a
reduction in the percentage of lottery ticket sales we receive from certain
customers resulting from contract rebids, extensions and renewals due to a
number of factors, including the substantial growth of lottery sales over the
last decade, reductions in the cost of technology and telecommunications
services, and general market and competitive dynamics. In anticipation and
response to these trends, beginning in fiscal 2001, we began the implementation
of our new Enterprise Series-led technology strategy combined with the
implementation of a number of ongoing cost savings initiatives and efficiency
improvement programs designed to enable us to maintain our market leadership in
the lottery industry. We are unable to determine at this time the likely effect
of this trend on our business.
-23-
Our business is highly regulated, and the competition to secure new government
contracts is often intense. From time to time, competitors challenge our
contract awards and there have been, and may continue to be, investigations of
various types, including grand jury investigations conducted by governmental
authorities into possible improprieties and wrongdoing in connection with
efforts to obtain and/or the awarding of lottery contracts and related matters.
In light of the fact that such investigations frequently are conducted in
secret, we may not necessarily know of the existence of an investigation which
might involve us. Because our reputation for integrity is an important factor in
our business dealings with lottery and other governmental agencies, a
governmental allegation or a finding of improper conduct on our part or
attributable to us in any manner could have a material adverse effect on our
business, including our ability to retain existing contracts or to obtain new or
renewal contracts. In addition, continuing adverse publicity resulting from
these investigations and related matters could have a material adverse effect on
our reputation and business. See the following for further information
concerning these matters and other contingencies:
- - "Legal Proceedings" in Part II, Item 1 in this report;
- - Part I, Item 1 - "Certain Factors That May Affect Future Performance -
Government regulations and other actions affecting the online lottery
industry could have a negative effect on our business and sales" in our
fiscal 2004 Annual Report on Form 10-K;
- - Part I, Item 3 - "Legal Proceedings" in our fiscal 2004 Annual Report on
Form 10-K;
- - Note 13 to the Consolidated Financial Statements in our fiscal 2004 Annual
Report on Form 10-K.
BRAZILIAN LEGAL PROCEEDINGS
Revenues from our lottery contract with Caixa Economica Federal ("CEF"), our
customer and the operator of Brazil's National Lottery, accounted for 9.7% of
our total fiscal 2004 revenues, making CEF our largest customer in fiscal 2004
based upon annual revenues.
A June 25, 2004 ruling in a civil action initiated by federal attorneys with
Brazil's Public Ministry will have the effect of materially reducing payments
that we otherwise would receive over the remaining term of our lottery contract
with CEF, which expires in May 2005. This ruling has ordered that 30% of
payments subsequent to the June 25, 2004 ruling due to GTECH Brasil Ltda., our
Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited in an
account maintained by the Court. In addition, the ruling ordered that all
assets of GTECH Brazil be identified to the Court so as to prevent their
transfer or disposition. As of May 29, 2004, GTECH Brazil assets approximated
$25.0 million. We estimate that this decision will reduce our service revenues
and pre-tax profits from our CEF contract by approximately $20 million during
the remainder of fiscal 2005. Pending our appeal of this ruling, we intend to
undertake a comprehensive review of our service and investment levels in
Brazil. Refer to "Legal Proceedings - Brazilian Legal Proceedings" in Part II,
Item 1 in this report; and Part 1, Item 3, "Legal Proceedings - Brazilian Legal
Proceedings, The CEF Contract Extension Proceedings," and Note 13 to the
Consolidated Financial Statements in our fiscal 2004 Annual Report on Form 10-K
for detailed disclosures regarding this, and related matters.
-24-
ACQUISITIONS
During the first quarter of fiscal 2005, we acquired privately-held Spielo
Manufacturing Incorporated ("Spielo"), a leading provider of video lottery
terminals ("VLT's") and related products and services to the global gaming
industry, for an all-cash purchase price of approximately $150 million. In
addition, we paid Spielo shareholders approximately $7 million out of a
potential maximum earn-out amount of up to $35 million, which Spielo
shareholders are entitled to receive in the 18 months following the closing,
based upon Spielo achieving certain VLT installation objectives in New York. By
acquiring Spielo, we will be better able to deliver a comprehensive, integrated
VLT solution to our existing and potential customers, with a single point of
contact and accountability.
We also acquired privately-held Leeward Islands Lottery Holding Company Inc.
("LILHCo"), a lottery operating company headquartered on the Caribbean islands
of Antigua and St. Croix, for an all-cash purchase price of approximately $40
million. By acquiring Caribbean-based LILHCo, we will enhance our strategic
foothold in that region, as well as provide significant growth opportunities in
additional jurisdictions throughout the Caribbean.
We continue to evaluate a variety of opportunities to broaden our offerings of
high-volume transaction processing services outside of our core market of
providing online lottery services, such as the processing and transmission of
commercial, non-lottery transactions including bill payments, electronic tax
payments, utility payments, prepaid cellular telephone recharges and
retail-based programs such as gift cards. Currently, our networks in Brazil,
Poland, Chile, the Czech Republic and Jamaica process bill payments and other
commercial service transactions. In the near term, we expect to concentrate our
efforts to grow commercial service revenues principally in the United States,
Latin America and Eastern Europe. While our goal is to leverage our technology,
infrastructure and relationships to drive growth in commercial services, if, in
the course of pursuing these opportunities, we identify an opportunity to gain
access to certain markets through the acquisition of existing businesses, we may
consider making such acquisitions.
OTHER BUSINESS DEVELOPMENTS
In April 2004, we were notified that our selection in February 2004 as the
apparent successful vendor to provide equipment and services for a new online
lottery system and associated telecommunications network in Mexico to
Pronosticos para la Asistencia Publica ("Pronosticos") was retracted. As part of
a ruling by the Mexican Comptroller Ministry on a protest filed by unsuccessful
competitors, our bid was declared non-compliant and disqualified. Subsequently,
Pronosticos announced that it disqualified the sole remaining bidder as also
being non-compliant and formally ended the procurement. We believe that we
submitted a fully compliant bid to Pronosticos that was in the best interest of
the lottery. We are pursuing all appropriate avenues available to contest the
Comptroller's decision. In the interim, as the incumbent lottery vendor, we will
continue to operate the lottery under our existing contract. In fiscal 2004, the
aggregate revenues from Pronosticos represented 1.3% of our consolidated
revenues.
In May 2004, we were notified by our customer, Loteria Electronica de Puerto
Rico ("Loteria Electronica"), of its intent to negotiate a contract to provide
equipment and services for a new online lottery system, terminals and associated
telecommunications network with another vendor to take effect upon the
expiration of our current contract in March 2005. In an effort to understand the
rationale behind the decision, we filed a petition with the Court of Appeals to
obtain a copy of the evaluation report, which was withheld by Loteria
Electronica. We also requested, and were granted, a stay of contract
negotiations between Loteria Electronica and the apparent successful vendor. We
are currently awaiting the court's decision. In fiscal 2004, the aggregate
revenues from Loteria Electronica represented 2.1% of our consolidated revenues.
-25-
OPERATIONS REVIEW
COMPARISON OF THE THREE MONTH PERIODS ENDED MAY 29, 2004 AND MAY 24, 2003
Revenues were $280.2 million in the first quarter of fiscal 2005, compared to
$239.6 million in the first quarter of fiscal 2004, up $40.6 million, or 17%.
The following discussion on service revenues should be read in conjunction with
the table below (in millions):
Three Months Ended
------------------------------------------------
Change
May 29, May 24, --------------------
Service revenues 2004 2003 $ %
- ---------------- ---------- ---------- ---------- ------
Domestic lottery $ 128.1 $ 120.9 $ 7.2 5.9
International lottery 98.5 85.8 12.7 14.7
Commercial services 20.4 12.0 8.4 70.5
Gaming solutions 5.6 4.2 1.4 33.8
All other 0.7 0.6 0.1 19.5
---------- ---------- ---------- ----
$ 253.3 $ 223.5 $ 29.8 13.3
========== ========== ========== ====
The 5.9% increase in domestic lottery service revenues was primarily due to
higher service revenues from an increase in sales by our domestic lottery
customers of approximately 6% with the balance principally due to the impact of
the Interlott acquisition in the third quarter of fiscal 2004, along with
higher jackpot activity and the launch of our new service contract in
Tennessee, partially offset by contractual rate changes. While we are not able
to quantify precisely the reasons for increases in sales by our domestic lottery
customers, we believe that in general, such increases are attributable to
enhanced marketing efforts by state lottery authorities seeking to offset
declining tax revenues and the successful introduction by state lottery
authorities of new games and products, modifications to existing games (such as
matrix changes and more frequent drawings) and expanded distribution channels,
such as Keno.
The 14.7% increase in international lottery service revenues includes higher
service revenues from an increase in sales by our international lottery
customers of approximately 4%, with the balance of the increase due to the
recognition of $5.0 million of deferred service revenue associated with our
contract in Taiwan, along with the impact of contractual rate changes, favorable
foreign exchange rates and the acquisition of LILHCo. While we are not able to
quantify precisely the reasons for increases in sales by our international
lottery customers, we believe that in general, such increases are attributable
to more rapid growth rates typical of newer lottery jurisdictions, the
successful introduction of new games and modifications to existing games (such
as matrix changes and more frequent drawings).
The 70.5% increase in commercial transaction processing service revenues was
primarily due to the acquisition of PolCard in the second quarter or fiscal
2004, which contributed $7.1 million of service revenues in the first quarter of
fiscal 2005.
The 33.8% increase in gaming solutions service revenues was primarily due to
the acquisition of Spielo and the installation of additional video lottery
terminals in existing jurisdictions.
Product, sales were $26.9 million in the first quarter of fiscal 2005, compared
to $16.0 million in the first quarter of fiscal 2004, up $10.9 million or 67.5%
principally due to the sale of terminals to our customer in Belgium and instant
ticket vending machines for Pennsylvania.
Our service margins were 41.9% in the first quarter of fiscal 2005 compared to
43.3% in the first quarter of fiscal 2004, primarily due to contractual rate
changes and the impact of higher depreciation and amortization related
principally to contract renewals and the implementation of new contracts,
partially offset by the recognition of deferred service revenue associated with
our contract in Taiwan.
-26-
Our product margins fluctuate depending on the mix, volume and timing of product
sales contracts. Our product margins were 40.8% in the first quarter of fiscal
2005 compared to 46.2% in the first quarter of fiscal 2004. This decline was
primarily due to the different mix of sales, with the prior year first quarter
including several small volume, high margin sales.
Operating expenses were $40.7 million in the first quarter of fiscal 2005,
compared to $38.7 million in the first quarter of fiscal 2004, up $2.0 million,
or 5.3%. This increase was driven by $3.3 million of increased spending on
selling, general and administrative expenses, principally due to the
consolidation of our recent acquisitions and increased activities in new
business development. Our investment in research and development decreased by
$1.3 million, primarily due to the timing of development initiatives, partially
offset by the impact of the Spielo acquisition. As a percentage of revenues,
operating expenses were 14.6% and 16.2% during the first quarters of fiscal 2005
and 2004, respectively.
The components of other income in the first quarters of fiscal 2005 and fiscal
2004 are as follows (in millions):
Three Months Ended
-----------------------------------
May 29, May 24,
2004 2003
---------------- -----------------
Gain on sale of investment $ 10.9 $ -
Foreign exchange gains (losses) 0.5 (0.8)
Minority interest in consolidated subsidiaries (0.4) (0.6)
Net charge associated with the early retirement of debt (0.8) -
Other 0.3 0.2
---------------- -----------------
Total other income $ 10.5 $ (1.2)
================ =================
The $10.9 million gain on sale of investment resulted from the sale in April
2004 of our 50% interest in Gaming Entertainment (Delaware) L.L.C. to Harrington
Raceway, Inc.
In May 2004, GTECH repurchased the remaining $90.0 million of its 7.87% Series B
Guaranteed Senior Notes due May 2007 (the "2007 Senior Notes"). In connection
with this repurchase, we incurred a net charge of $0.8 million, principally
comprised of a redemption premium net of deferred interest rate swap gains.
Interest expense was $4.3 million in the first quarter of fiscal 2005, compared
to $2.3 million in the first quarter of fiscal 2004, up $2.0 million, or 88%.
This increase was primarily due to higher debt balances resulting from the
issuance of $250 million of 4.75% Senior Notes in the third quarter of fiscal
2004.
Weighted average diluted shares in the first quarter of fiscal 2005 increased by
7.3 million shares to 67.5 million shares, primarily due to the assumed
conversion of our $175 million principal amount of 1.75% Convertible Debentures
(the "Debentures") into shares of our common stock, resulting in a decrease to
diluted earnings per share of approximately $0.08. These Debentures are
convertible at the option of the holder into shares of our common stock at a
conversion price of approximately $27.50 per share when, among other
circumstances, our stock closes above $33 per share for at least 20 out of 30
consecutive trading days prior to the date of surrender for conversion. There
are a total of 6.4 million shares issuable upon the conversion of the
Debentures. The Debentures were convertible for all 64 trading days in the first
quarter of fiscal 2005, and accordingly, 6.4 million shares were included in the
computation of diluted earnings per share. For the first quarter of fiscal 2004,
the Debentures were convertible for 17 out of 64 trading days, and accordingly,
1.7 million shares were included in the computation of diluted earnings per
share.
-27-
Our effective income tax rate of 37% in the first quarter of fiscal 2005 was
comparable to the first quarter of fiscal 2004. We expect the second quarter tax
rate to be comparable to the first quarter rate of 37%. We currently expect that
our full-year effective income tax rate will be approximately 36% based on the
pending resolution of certain tax contingencies and the recent acquisitions of
non-U.S.-based companies. Our aggregate income tax rate in foreign jurisdictions
is lower than our income tax rate in the United States. Our income tax rate may
vary, however, depending on the composition of income or loss in different
countries and the resolution of audits and tax contingencies.
LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION
We believe our ability to generate cash from operations to reinvest in our
business is one of our fundamental financial strengths and we expect to meet our
financial commitments and operating needs in the foreseeable future. We expect
to use cash generated from operating activities primarily for aggregate
contractual obligations and to pay dividends. We expect our growth to be
financed through a combination of cash generated from operating activities,
existing sources of liquidity, access to capital markets and other sources of
capital. Our debt ratings of Baa1 from Moody's and BBB (positive outlook) from
Standard and Poor's contribute to our ability to access capital markets at
attractive prices. These ratings reflect several factors, including our strong
cash flows and balance sheet.
ANALYSIS OF CASH FLOWS
During the first quarter of fiscal 2005, we generated $96.4 million of cash from
operations which, along with cash on hand, available-for-sale investment
securities and proceeds of $11.8 million from the sale of our 50% interest in
Gaming Entertainment (Delaware) L.L.C., was principally used to fund the Spielo
and LILHCo acquisitions of $193.0 million and to purchase $53.9 million of
systems, equipment and other assets relating to contracts. In addition, we
repaid the remaining $90.0 million of our 7.87% Senior Notes and paid a related
redemption premium of $10.6 million; repurchased $28.3 million, or 545,000
shares, of our common stock; and paid cash dividends of $10.1 million. At May
29, 2004, we had $60.2 million of cash and cash equivalents on hand and $12.1
million of available-for-sale investment securities.
Our business is capital-intensive. We currently estimate that net cash to be
used for investing activities in fiscal 2005, excluding net purchases of
available-for-sale investment securities, will be in the range of $550 million
to $570 million, including investments we made to acquire Spielo and LILHCo. We
expect our principal sources of liquidity to be existing cash and
available-for-sale investment securities, along with cash we generate from
operations. Our credit facility provides for an unsecured revolving line of
credit of $300 million and matures in June 2006. As of May 29, 2004, there were
no borrowings under the credit facility. Up to $100 million of the Credit
Facility may be used for the issuance of letters of credit. As of May 29, 2004
and June 23, 2004, after considering $8.5 million and $29.5 million of letters
of credit issued and outstanding, there was $291.5 million and $270.5 million
available for borrowing under the Credit Facility, respectively.
We currently expect that our cash flow from operations, existing cash,
available-for-sale investment securities, available borrowings under our credit
facility and access to additional sources of capital will be sufficient, for the
foreseeable future, to fund our anticipated working capital and ordinary capital
expenditure needs, to service our debt obligations, to fund anticipated internal
growth, to fund all or a portion of the cash needed for potential acquisitions,
to pay dividends, to fund the capital requirements under our Master Contract
with the Rhode Island Lottery and to repurchase shares of our common stock, from
time to time, under our share repurchase programs. We may also seek alternative
sources of financing to fund certain of our obligations under our Master
Contract with the Rhode Island Lottery and to fund future potential acquisitions
and growth opportunities that are not currently contemplated in the $550 million
to $570 million we estimate we will need in fiscal 2005 for the uses disclosed
above.
-28-
FINANCIAL POSITION
Our balance sheet as of May 29, 2004, as compared to our balance sheet as of
February 28, 2004, was impacted by our acquisitions of Spielo and LILHCo.
Drivers of the material changes in each specific balance sheet category are
described below.
Investment securities available-for-sale decreased by $209.8 million, from
$221.9 million at February 28, 2004 to $12.1 million at May 29, 2004, reflecting
the $193.0 million payment for the Spielo and LILHCo acquisitions.
Trade accounts receivable, net increased by $11.5 million, from $118.9 million
at February 28, 2004 to $130.4 million at May 29, 2004, primarily due to $6.0
million related to the Spielo and LILHCo acquisitions.
Inventories increased by $20.6 million, from $76.8 million at February 28, 2004
to $97.4 million at May 29, 2004, primarily due to $11.2 million of inventory
associated with the acquisition of Spielo, along with an increase in inventory
associated with product sales expected to be recorded during the second and
fourth quarters of fiscal 2005.
Systems, equipment and other assets relating to contracts, net, increased by
$29.3 million, from $591.4 million at February 28, 2004 to $620.7 million at May
29, 2004, primarily due to the purchase of $53.9 million of systems, equipment
and other assets relating to contracts (principally related to lottery system
implementations in Wisconsin and Tennessee, lottery equipment installations in
Texas, and the acquisition of Spielo), partially offset by depreciation expense.
Goodwill, net, increased by $124.1 million, from $188.6 million at February 28,
2004 to $312.7 million at May 29, 2004, primarily due to the acquisitions of
Spielo and LILHCo.
Intangible assets, net, increased by $69.4 million, from $28.2 million at
February 28, 2004 to $97.6 million at May 29, 2004, due to intangible assets
recorded as a result of our acquisitions of Spielo and LILHCo.
Employee compensation decreased by $12.0 million, from $34.0 million at February
28, 2004 to $22.0 million at May 29, 2004, primarily due to the payment of
incentive compensation and profit sharing in April 2004.
Advance payments from customers increased by $23.1 million, from $104.1 million
at February 28, 2004 to $127.2 million at May 29, 2004, primarily due to
advances from customers, including those related to product sales that are
expected to be recorded during fiscal 2005 and 2006, partially offset by the
sale of terminals to our customer in Belgium.
Deferred revenue and advance billings increased by $16.1 million, from $14.5
million at February 28, 2004 to $30.6 million at May 29, 2004, primarily due to
customer progress billings related to product sales expected to be recorded in
the second quarter of fiscal 2005.
Income taxes payable increased by $9.0 million, from $12.4 million at February
28, 2004 to $21.4 million at May 29, 2004, primarily due to the timing of
estimated tax payments.
Current portion of long-term debt decreased by $100.5 million, from $106.3
million at February 28, 2004 to $5.8 million at May 29, 2004, primarily due to
the repayment in May 2004 of the remaining $90.0 million of our 7.87% Senior
Notes.
Deferred income taxes increased by $27.7, from $61.7 million at February 28,
2004 to $89.4 million at May 29, 2004 primarily due to deferred taxes associated
with the Spielo and LILHCo acquisitions.
-29-
POTENTIAL COMMITMENTS
Master Contract with the Rhode Island Lottery
As previously reported, on May 12, 2003, we entered into a Master Contract with
the Rhode Island Lottery (the "Lottery") that amends our existing contracts with
the Lottery and grants us the right to be the exclusive provider of online,
instant ticket and video lottery central systems and services for the Lottery
during the 20-year term of the Master Contract for a $12.5 million up-front
license fee which we paid in July 2003. Under the terms of the Master Contract,
we are to invest (or cause to be invested) at least $100 million in the State of
Rhode Island, in the aggregate, by December 31, 2008. This investment commitment
includes the $12.5 million up-front license fee; new online and video lottery
related hardware, software and services; the development of a new world
headquarters facility of at least 210,000 square feet in Providence, Rhode
Island by December 31, 2006; and improvements to our existing manufacturing
facility in West Greenwich, Rhode Island. We have agreed to employ at least
1,000 people full-time in Rhode Island by the end of calendar year 2005 and
maintain that level of employment thereafter. In the event the State of Rhode
Island takes certain actions which affect our financial performance, we will be
automatically released from the in-state employment obligation. In addition to
being released from the employment requirement, we would be released from our
obligations to invest (or cause to be invested) the $100 million, replace the
online lottery gaming system, deliver certain other online lottery deliverables
and replace the video lottery central system (all to the extent such obligations
remain unperformed) and would be entitled to a refund of a pro-rata portion of
the license fee. We currently plan to satisfy our obligation to invest (or cause
to be invested) at least $100 million in the State of Rhode Island by December
31, 2008 as follows: (i) approximately $24 million that was invested during
fiscal 2004; (ii) approximately $32 million that will be invested during fiscal
2005; and (iii) the balance that will be invested during fiscal 2006. The
Lottery may terminate the Master Contract in the event that we fail to meet our
obligations as stated above.
In addition, in July 2003 we entered into a tax stabilization agreement with the
City of Providence (the "City"), whereby the City agreed to stabilize the real
estate and personal property taxes payable in connection with our new world
headquarters facility in the City and the personal property associated with such
facility for 20 years. We also agreed to complete and occupy the facility by
December 31, 2006, employ 500 employees at the facility by 2009, and we made
certain commitments regarding our employment, purchasing and education
activities in the City.
In June 2004, the Rhode Island legislature voted to approve a gaming facility
development proposal, and to place such proposal before Rhode Island voters for
consideration in a November 2004 referendum. The proposal passed by the Rhode
Island legislature makes no provision for us to be a supplier of a percentage
of the gaming machines in the proposed gaming facility, as we believe is
contemplated by the Master Contract. Rhode Island Governor Carcieri has vetoed
this legislation. It is widely anticipated, however, that the Rhode Island
legislature will act to override Governor Carcieri's veto. In such event, and
subject to the proposal receiving the requisite approval by Rhode Island
voters, there can be no assurance that this gaming facility development
proposal will not be implemented in accordance with its terms. We understand
there are questions regarding the constitutionality of this legislation. We
are reviewing our rights and obligations under the Master Agreement in light of
these developments.
-30-
FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY
FINANCIAL RISK MANAGEMENT
The primary market risk inherent in our financial instruments and exposures is
the potential loss arising from adverse changes in interest rates and foreign
currency exchange rates. Our exposure to commodity price changes is not
considered material and is managed through our procurement and sales practices.
We use various techniques to manage our market risks, including from time to
time, the use of derivative instruments. We manage our exposure to counterparty
credit risk by entering into financial instruments with major, financially sound
counterparties with high-grade credit ratings and by limiting exposure to any
one counterparty. We do not engage in currency or interest rate speculation.
INTEREST RATE MARKET RISK
Interest rate market risk is estimated as the potential change in the fair value
of our total debt or current earnings resulting from a hypothetical 10% adverse
change in interest rates.
The estimated fair value of our long-term debt and change in the estimated fair
value due to hypothetical changes in interest rates are as follows (dollars in
millions):
Estimated Fair Value
-----------------------------------------------------------
At May 29, 10% Increase in 10% Decrease in
2004 Interest Rates Interest Rates
--------------- ------------------ -------------------
$250 million of 4.75% Senior Notes $ 247.1 $ 246.1 $ 248.1
$175 million of 1.75% Convertible
Debentures 362.3 362.0 362.5
The estimated fair values above were determined by an independent investment
banker and the values of the Senior Notes were determined after taking into
consideration $150 million of interest rate swaps. A hypothetical 10% adverse or
favorable change in interest rates applied to variable rate debt would not have
a material effect on current earnings.
We use various techniques to mitigate the risk associated with future changes in
interest rates, including entering into interest rate swaps.
EQUITY PRICE RISK
The estimated fair value of our $175 million of 1.75% Convertible Debentures and
change in the estimated fair value due to hypothetical changes in the market
price of our common stock is as follows (dollars in millions):
Estimated Fair Value
-----------------------------------------------------------
10% Increase in 10% Decrease in
At May 29, Market Price of Market Price of
2004 Common Stock Common Stock
--------------- ------------------ -------------------
$175 million of 1.75% Convertible
Debentures $ 362.3 $ 396.7 $ 328.5
The estimated fair values above were determined by an independent investment
banker and were based on a quoted market price of $207.00 per Debenture.
-31-
FOREIGN CURRENCY EXCHANGE RATE RISK
We are subject to foreign exchange exposures arising from current and
anticipated transactions denominated in currencies other than our functional
currency, which is United States dollars, and from the translation of foreign
currency balance sheet accounts into United States dollar balance sheet
accounts.
We seek to manage our foreign exchange risk by securing payment from our
customers in United States dollars, by sharing risk with our customers, by
utilizing foreign currency borrowings, by leading and lagging receipts and
payments, and by entering into foreign currency exchange and option contracts.
In addition, a significant portion of the costs attributable to our foreign
currency revenues are payable in the local currencies. In limited circumstances,
but whenever possible, we negotiate clauses into our contracts that allow for
price adjustments should a material change in foreign exchange rates occur.
From time to time, we enter into foreign currency exchange and option contracts
to reduce the exposure associated with certain firm commitments, variable
service revenues and certain assets and liabilities denominated in foreign
currencies, but we do not engage in foreign currency speculation. These
contracts generally have maturities of 12 months or less and are regularly
renewed to provide continuing coverage throughout the year. At May 29, 2004, a
hypothetical 10% adverse change in foreign exchange rates would result in a
translation loss of $22.3 million that would be recorded in the equity section
of our balance sheet.
At May 29, 2004, a hypothetical 10% adverse change in foreign exchange rates
would result in a net pre-tax transaction loss of $2.7 million that would be
recorded in current earnings after considering the effects of foreign exchange
contracts currently in place.
At May 29, 2004, a hypothetical 10% adverse change in foreign exchange rates
would result in a net reduction of cash flows from anticipatory transactions
during the remainder of fiscal 2005 of $12.5 million, after considering the
effects of foreign exchange contracts currently in place. The percentage of
fiscal 2005 first quarter anticipatory cash flows that were hedged varied
throughout the quarter, but averaged 28%.
As of May 29, 2004, we had contracts for the sale of foreign currency of
approximately $71.0 million (primarily Euro, Brazilian real and pounds sterling)
and the purchase of foreign currency of approximately $57.0 million (primarily
Canadian dollar, Brazilian real, New Taiwan dollars, pounds sterling and Swedish
krona).
DIVIDEND POLICY
We are committed to returning value to our shareholders. Beginning in the second
quarter of fiscal 2004, we commenced paying cash dividends on our common stock
of $0.17 per share, equivalent to a full-year dividend of $0.68 per share. We
currently plan to continue paying dividends in the foreseeable future.
SUBSEQUENT EVENT
On June 17, 2004, our Board of Directors approved a 2-for-1 common stock split,
payable in the form of a stock dividend, which entitles each shareholder of
record on July 1, 2004 to receive one share of common stock for each outstanding
share of common stock held on that date. The stock dividend will be distributed
on July 30, 2004. All references to common shares and per share amounts herein
are presented on a pre-split basis.
-32-
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Financial Risk Management" above.
Item 4. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our Securities Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commission's rules and forms, and that such
information is accumulated and communicated to our management, including our
President and Chief Executive Officer ("CEO") and our Senior Vice President and
Chief Financial Officer ("CFO"), as appropriate, to allow timely decisions
regarding required disclosure. In designing and evaluating the disclosure
controls and procedures, management recognized that any controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance
of achieving the desired control objectives and management was required to apply
its judgment in evaluating the cost-benefit relationship of possible controls
and procedures. Our controls and procedures are designed to provide a reasonable
level of assurance in reaching our desired controls and procedures objectives.
As of the end of the quarterly period covered by this report, we carried out an
evaluation under the supervision and with the participation of our management,
including our CEO and our CFO, of the effectiveness of the design and operation
of our disclosure controls and procedures (as defined in Rule 13a-14(c) under
the Securities Exchange Act of 1934). Based upon that evaluation, the CEO and
CFO concluded that the Company's disclosure controls and procedures were
effective in reaching a reasonable level of assurance of achieving management's
desired controls and procedures objectives. In the first quarter of fiscal 2005,
there were no significant changes in our internal controls or in other factors
that could significantly affect these controls, and no corrective actions have
been taken with regard to significant deficiencies or material weaknesses in
such controls.
-33-
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
BRAZILIAN LEGAL PROCEEDINGS
CIVIL ACTION BY THE PUBLIC MINISTRY ATTORNEYS
As previously reported, a civil action has been initiated by federal attorneys
with Brazil's Public Ministry (the "Public Ministry Attorneys") in the Federal
Court of Brasilia against GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH
Brazil"); 17 former officers and employees of Caixa Economica Federal, the
Brazilian bank and operator of Brazil's National Lottery ("CEF"); the former
president of Racimec; Antonio Carlos Rocha, the former Senior Vice President of
GTECH Holdings Corporation and President of GTECH Brazil, and Marcos Andrade,
another former officer of GTECH Brazil. The focus of this civil action is the
contractual relationship between CEF, GTECH Brazil and GTECH Brazil's
predecessor company, Racimec Informatica Brasileira S.A., for the period from
1994 to 2002. This civil action, which alleges that the defendants acted
illegally in entering into, amending and performing the 1997 Contract and the
2000 Contract, seeks to invalidate the 2000 Contract (which, as extended, is
still in force). This lawsuit also seeks to impose penalties equal to the sum of
all amounts paid to us under the 1997 Contract and the 2000 Contract from
January 1997 to present, which we estimate to be approximately US$650 million at
current exchange rates, plus certain other permitted amounts, minus our proven
investment costs.
We learned earlier this week that on June 25, 2004 the judge hearing this civil
action granted a procedural injunction ordering that 30% of payments due to
GTECH Brazil from CEF under the 2000 Contract be withheld and deposited into an
account maintained by the Court. The judge held that, as a foreign company doing
business in Brazil, we do not have adequate in-country holdings to satisfy the
potential claims should the plaintiff prevail in this lawsuit. This order
provides a process to change the percentage of our payments to be withheld based
upon a determination of our effective cost of servicing the 2000 Contract. The
Court also ordered that all assets of GTECH Brazil be identified to the Court so
as to prevent their transfer or disposition.
The injunction was granted as part of a confidential ex parte proceeding in
which we were not afforded an opportunity to participate. We intend to appeal
the decision to grant this injunction. Pending the outcome of this appeal, we
will undertake a comprehensive review of our service and investment levels in
Brazil.
With regard to the underlying civil action, we continue to believe that we have
good and adequate defenses. We intend to vigorously defend ourselves in the
proceedings.
CRIMINAL ALLEGATIONS AGAINST CERTAIN EMPLOYEES
As previously reported, in late March 2004 the Public Ministry Attorneys
recommended that criminal charges be brought against nine individuals, including
four senior officers of CEF; Antonio Carlos Rocha, the former Senior Vice
President of GTECH Holdings Corporation and President of GTECH Brazil; and
Marcelo Rovai, GTECH Brazil's marketing director. No other present or former
employee of the Company has been implicated by the Public Ministry Attorneys.
The Company is not the subject of this criminal investigation, and under
Brazilian law (which provides that criminal charges may not be brought against
corporations or other entities), we cannot be subject to criminal charges in
connection with this matter. We understand that the Public Ministry Attorneys
had recommended that Messrs. Rocha and Rovai be charged with offering an
improper inducement in connection with the negotiation of the contract extension
that we entered into in April 2003 to the 2000 Contract (the "2003 Contract").
We further understand that the Public Ministry Attorneys had recommended that
Messrs. Rocha and Rovai be charged with effectively co-authoring or aiding and
abetting certain allegedly fraudulent or inappropriate management practices of
the CEF management who agreed to enter into the 2003 Contract Extension.
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GTECH recently has learned that the judge reviewing these charges prior to their
being filed has refused to initiate the criminal charges against the nine
individuals, including against Messrs Rocha and Rovai. The judge chose not to
accept any elements of the charges, as was his prerogative, but instead, has
granted a request by the Brazilian Federal Police to continue the investigation
which had been suspended by the recommendations of the Pubic Ministry Attorneys.
The judge cited the prosecutors' rush to bring charges in response to the
pressure of public opinion as a contributing factor to his decision to return
the investigation to the Federal Police. The judge's order pertained to
procedural aspects and not to the merits of the charges.
We have cooperated fully with the investigation by Brazilian authorities
respecting this matter, and have encouraged Messrs Rocha and Rovai to do the
same. Moreover, the United States Securities and Exchange Commission has made an
informal inquiry as to this matter, and we are cooperating fully with its
inquiry. In addition, GTECH is currently conducting an internal investigation of
this matter that is nearing its completion. We are satisfied from our
preliminary findings that we have acted appropriately.
OTHER LEGAL PROCEEDINGS
SHAREHOLDER CLASS ACTION SUIT
As previously reported, we, together with William Y. O'Connor, our former
Chairman and Chief Executive Officer, Steven P. Nowick, our former President and
Chief Operating Officer, and W. Bruce Turner, our former Chairman and current
President and Chief Executive Officer, were named as defendants in a shareholder
class action suit captioned Sandra Kafenbaum and Steven Schulman, individually
and on behalf of all others similarly situated v. GTECH Holdings Corporation,
et. al., which suit was filed in the U.S. District Court of Rhode Island in
August 2000 and subsequently amended in February 2001.
We recently have entered into an agreement with plaintiffs to settle this class
action lawsuit on terms that would require payment by us of amounts that, after
taking into account certain insurance proceeds that we expect to receive, will
not be material to our financial condition or results of operation. We have
previously fully reserved against such payments required of the Company. Final
settlement is subject to court approval after a fairness hearing at which any
objectors to the settlement will be provided the opportunity to present their
views. This fairness hearing is scheduled to take place in September 2004.
For further information respecting certain other legal proceedings, see Item 1,
"Certain Factors Affecting Future Performance," Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations," and Item 8, Note
13 to Notes to Consolidated Financial Statements of our fiscal 2004 Annual
Report on Form 10-K.
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Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits - The exhibits to this report are as follows:
12.1 Computation of Ratio of Earnings to Fixed Charges
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002, of W. Bruce Turner, President and Chief Executive Officer of
the Company
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002, of Jaymin B. Patel, Senior Vice President and Chief Financial
Officer of the Company
32.1 Certification Pursuant to 18 United States Code Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
of W. Bruce Turner, President and Chief Executive Officer of the
Company
32.2 Certification Pursuant to 18 United States Code Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
of Jaymin B. Patel, Senior Vice President and Chief Financial
Officer of the Company
(b) Reports on Form 8-K - We filed the following report with the Securities
and Exchange Commission on Form 8-K during the quarter to which this
report relates:
(i) We filed a report on Form 8-K on April 15, 2004 incorporating by
reference a press release we issued on April 15, 2004 announcing our
fiscal 2004 fourth quarter and year end results. In addition, we
incorporated by reference the transcripts and slide presentation
from our fiscal 2004 fourth quarter and year earnings conference
call held on April 15, 2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
GTECH HOLDINGS CORPORATION
Date: July 2, 2004 By /s/ Jaymin B. Patel
--------------------------------------------------
Jaymin B. Patel, Senior Vice President and Chief
Financial Officer (Principal Financial Officer)
Date: July 2, 2004 By /s/ Robert J. Plourde
--------------------------------------------
Robert J. Plourde, Vice President, Corporate
Controller and Chief Accounting Officer
(Principal Accounting Officer)
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