-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, BMeIT7W7Aw+bB1k76uw2N3TkSW3MkSrdqPsol0U2dLj1O0FQNcIr5GYU2j+JgWfL TtvJq/wmkWBV1ekT3pmg1g== 0000950123-03-011026.txt : 20031001 0000950123-03-011026.hdr.sgml : 20031001 20031001142959 ACCESSION NUMBER: 0000950123-03-011026 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20030823 FILED AS OF DATE: 20031001 FILER: COMPANY DATA: COMPANY CONFORMED NAME: GTECH HOLDINGS CORP CENTRAL INDEX KEY: 0000857323 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROGRAMMING, DATA PROCESSING, ETC. [7370] IRS NUMBER: 050450121 STATE OF INCORPORATION: DE FISCAL YEAR END: 0223 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-11250 FILM NUMBER: 03920111 BUSINESS ADDRESS: STREET 1: 55 TECNOLOGY WAY CITY: WEST GREENWICH STATE: RI ZIP: 02817 BUSINESS PHONE: 4013921000 MAIL ADDRESS: STREET 1: 55 TECHNOLOGY WAY STREET 2: LEGAL DEPARTMENT CITY: WEST GREENWICH STATE: RI ZIP: 02817 10-Q 1 y90247e10vq.txt FORM 10-Q 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 August 23, 2003 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 - -------------------------------------------------------------------------------- (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 [ ] At September 29, 2003, there were 58,952,267 shares of the registrant's Common Stock outstanding. INDEX GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
Page Number ------ PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Income Statements 4-5 Consolidated Statements of Cash Flows 6 Consolidated Statements of Shareholders' Equity 7 Notes to Consolidated Financial Statements 8-25 Item 2. Management's Discussion and Analysis of Financial Condition 26-42 and Results of Operations Item 3. Quantitative and Qualitative Disclosures about Market Risk 43 Item 4. Controls and Procedures 43 PART II. OTHER INFORMATION Item 1. Legal Proceedings 44 Item 4. Submission of Matters to a Vote of Security Holders 45 Item 6. Exhibits and Reports on Form 8-K 46 SIGNATURES 47 EXHIBITS
PART 1. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
(Unaudited) August 23, February 22, 2003 2003 ----------- ------------ (Dollars in thousands) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 94,322 $ 116,174 Trade accounts receivable, net 106,564 107,666 Sales-type lease receivables 4,213 4,400 Inventories 57,448 72,287 Deferred income taxes 29,410 29,410 Other current assets 28,849 18,660 ----------- ----------- TOTAL CURRENT ASSETS 320,806 348,597 SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS, net 504,348 410,911 GOODWILL, net 146,995 115,498 OTHER ASSETS 97,862 79,189 ----------- ----------- TOTAL ASSETS $ 1,070,011 $ 954,195 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 63,375 $ 74,042 Accrued expenses 53,565 51,200 Employee compensation 28,335 37,494 Advance payments from customers 62,508 52,442 Deferred revenue and advance billings 12,654 17,264 Income taxes payable 50,118 54,043 Taxes other than income taxes 25,262 16,020 Short term borrowings 2,219 2,616 Current portion of long-term debt 8,813 6,992 ----------- ----------- TOTAL CURRENT LIABILITIES 306,849 312,113 LONG-TERM DEBT, less current portion 286,595 287,088 OTHER LIABILITIES 42,942 39,428 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, 92,296,404 and 92,296,404 shares issued; 58,235,704 and 56,638,331 shares outstanding at August 23, 2003 and February 22, 2003, respectively 923 923 Additional paid-in capital 245,962 235,266 Accumulated other comprehensive loss (91,433) (95,488) Retained earnings 765,230 684,653 ----------- ----------- 920,682 825,354 Less cost of 34,060,700 and 35,658,073 shares in treasury at August 23, 2003 and February 22, 2003, respectively (487,057) (509,788) ----------- ----------- 433,625 315,566 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,070,011 $ 954,195 =========== ===========
See Notes to Consolidated Financial Statements -3- CONSOLIDATED INCOME STATEMENTS GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
(Unaudited) Three Months Ended -------------------------- August 23, August 24, 2003 2002 ----------- ----------- (Dollars in thousands, except per share amounts) Revenues: Services $ 238,019 $ 211,600 Sales of products 39,228 9,358 ----------- ----------- 277,247 220,958 Costs and expenses: Costs of services 132,805 126,942 Costs of sales 28,810 4,109 ----------- ----------- 161,615 131,051 ----------- ----------- Gross profit 115,632 89,907 Selling, general and administrative 27,051 22,901 Research and development 14,106 7,170 ----------- ----------- Operating expenses 41,157 30,071 ----------- ----------- Operating income 74,475 59,836 Other income (expense): Interest income 1,021 977 Equity in earnings of unconsolidated affiliates 2,691 1,261 Other income 465 2,269 Interest expense (1,705) (2,718) ----------- ----------- 2,472 1,789 ----------- ----------- Income before income taxes 76,947 61,625 Income taxes 28,471 23,418 ----------- ----------- Net income $ 48,476 $ 38,207 =========== =========== Basic earnings per share $ 0.84 $ 0.67 =========== =========== Diluted earnings per share $ 0.74 $ 0.66 =========== =========== Weighted average shares outstanding - basic 57,918 57,225 =========== =========== Weighted average shares outstanding - diluted 65,908 58,299 =========== =========== Dividends per share - common stock $ 0.17 $ - =========== ===========
See Notes to Consolidated Financial Statements -4- CONSOLIDATED INCOME STATEMENTS GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
(Unaudited) Six Months Ended ------------------------- August 23, August 24, 2003 2002 ---------- ------------ (Dollars in thousands, except per share amounts) Revenues: Services $461,557 $ 435,335 Sales of products 55,275 17,035 -------- ----------- 516,832 452,370 Costs and expenses: Costs of services 259,602 273,877 Costs of sales 37,439 10,356 -------- ----------- 297,041 284,233 -------- ----------- Gross profit 219,791 168,137 Selling, general and administrative 51,331 45,810 Research and development 28,496 13,672 -------- ----------- Operating expenses 79,827 59,482 -------- ----------- Operating income 139,964 108,655 Other income (expense): Interest income 2,209 1,819 Equity in earnings of unconsolidated affiliates 4,620 1,957 Other income (expense) (715) 1,678 Interest expense (4,011) (5,643) -------- ----------- 2,103 (189) -------- ----------- Income before income taxes 142,067 108,466 Income taxes 52,565 41,218 -------- ----------- Net income $ 89,502 $ 67,248 ======== =========== Basic earnings per share $ 1.56 $ 1.17 ======== =========== Diluted earnings per share $ 1.43 $ 1.14 ======== =========== Weighted average shares outstanding - basic 57,413 57,387 ======== =========== Weighted average shares outstanding - diluted 62,994 58,763 ======== =========== Dividends per share - common stock $ 0.17 $ - ======== ===========
See Notes to Consolidated Financial Statements -5- CONSOLIDATED STATEMENTS OF CASH FLOWS GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
(Unaudited) Six Months Ended ----------------------- August 23, August 24, 2003 2002 ---------- ---------- (Dollars in thousands) OPERATING ACTIVITIES Net income $ 89,502 $ 67,248 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 51,924 66,619 Intangibles amortization 1,762 3,369 Tax benefit related to stock award plans 10,696 7,299 Equity in earnings of unconsolidated affiliates, net of dividends received (289) 653 Other 3,748 3,731 Changes in operating assets and liabilities: Trade accounts receivable 9,769 8,490 Inventories 14,839 (12,780) Other assets and liabilities (11,497) 55,024 --------- --------- NET CASH PROVIDED BY OPERATING ACTIVITIES 170,454 199,653 INVESTING ACTIVITIES Purchases of systems, equipment and other assets relating to contracts (143,774) (88,395) Acquisitions (net of cash acquired) (41,023) - License fee (12,500) - Investments in and advances to unconsolidated subsidiaries (1,185) - Other (6,285) (2,950) --------- --------- NET CASH USED FOR INVESTING ACTIVITIES (204,767) (91,345) FINANCING ACTIVITIES Net proceeds from issuance of long-term debt 1,409 - Principal payments on long-term debt (2,146) (3,616) Purchases of treasury stock - (42,453) Proceeds from stock options 21,101 14,331 Dividends paid (9,883) - Other (484) 1,504 --------- --------- NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES 9,997 (30,234) Effect of exchange rate changes on cash 2,464 1,737 --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (21,852) 79,811 Cash and cash equivalents at beginning of period 116,174 35,095 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 94,322 $ 114,906 ========= =========
See Notes to Consolidated Financial Statements -6- CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - (Unaudited) GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
Accumulated Additional Other Outstanding Common Paid-in Comprehensive Shares Stock Capital Income (Loss) ----------- --------- ----------- ------------- (Dollars in thousands) Balance at February 22, 2003 56,638,331 $ 923 $ 235,266 $ (95,488) Comprehensive income: Net income - - - - Other comprehensive income (loss), net of tax: Foreign currency translation - - - 5,104 Unrecognized net loss on derivative instruments - - - (1,048) Unrealized loss on investments - - - (1) Comprehensive income Cash dividends on common stock ($0.17 per share) - - - - Shares issued under employee stock purchase and stock award plans 139,197 - - - Shares issued upon exercise of stock options 1,458,176 - - - Tax benefits related to stock award plans - - 10,696 - ---------- --------- ----------- ----------- Balance at August 23, 2003 58,235,704 $ 923 $ 245,962 $ (91,433) ========== ========= =========== =========== Retained Treasury Earnings Stock Total ----------- ------------ ---------- (Dollars in thousands) Balance at February 22, 2003 $ 684,653 $ (509,788) $ 315,566 Comprehensive income: Net income 89,502 - 89,502 Other comprehensive income (loss), net of tax: Foreign currency translation - - 5,104 Unrecognized net loss on derivative instruments - - (1,048) Unrealized loss on investments - - (1) ---------- Comprehensive income 93,557 Cash dividends on common stock ($0.17 per share) (9,956) - (9,956) Shares issued under employee stock purchase and stock award plans 681 1,980 2,661 Shares issued upon exercise of stock options 350 20,751 21,101 Tax benefits related to stock award plans - - 10,696 ----------- ------------ ----------- Balance at August 23, 2003 $ 765,230 $ (487,057) $ 433,625 =========== ============ ===========
See Notes to Consolidated Financial Statements -7- 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 information technology company providing software, networks and professional services that power high-performance, transaction processing solutions. When used in these notes, the terms "Holdings", "the Company", "we", "our", and "us" refer to GTECH Holdings Corporation and its consolidated subsidiaries, unless otherwise specified. We have a single operating and reportable business segment, the Transaction Processing segment. Our core market is the lottery industry, with a growing presence in commercial services transaction processing. 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 2003 Annual Report on Form 10-K, as amended. 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 six-month period ended August 23, 2003 are not necessarily indicative of the results that may be expected for the full fiscal year ending February 28, 2004. The balance sheet at February 22, 2003 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 2003 Annual Report on Form 10-K, as amended. Certain amounts in our prior period financial statements have been reclassified to conform to the current period presentation. 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. -8- 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 Six Months Ended -------------------------- -------------------------- August 23, August 24, August 23, August 24, 2003 2002 2003 2002 ------------ ------------ ------------ ----------- (Dollars and shares in thousands, except per share amounts) Net income, as reported $ 48,476 $ 38,207 $ 89,502 $ 67,248 Deduct: Total stock-based compensation expense determined under the fair value method for all awards, net of related tax effects (1,432) (1,752) (2,909) (3,431) ------------ ------------ ------------ ----------- Pro forma net income $ 47,044 $ 36,455 $ 86,593 $ 63,817 ============ ============ ============ =========== Basic earnings per share: As reported $ .84 $ .67 $ 1.56 $ 1.17 Pro forma .81 .64 1.51 1.11 Diluted earnings per share: As reported $ .74 $ .66 $ 1.43 $ 1.14 Pro forma .72 .63 1.39 1.09
NOTE 2 - BUSINESS ACQUISITIONS POLCARD S.A. On May 28, 2003, we completed the acquisition of a controlling equity position in PolCard S.A. ("PolCard"), for a purchase price, net of cash acquired, of $35.9 million. PolCard is the largest debit and credit card merchant transaction acquirer and processor in Poland. At August 23, 2003, PolCard's outstanding equity was owned 66.5% by us, 33.2% by two funds managed by Innova Capital Sp. zo.o ("Innova"), a Warsaw-based private equity investment advisor, and 0.3% by the Polish Bank Association, one of PolCard's previous owners. In September 2003 (after the close of our fiscal 2004 second quarter), Innova exercised its rights under an option agreement to purchase from us, 3.7% of PolCard's equity for a purchase price of $2.3 million. Following the exercise of this right, we now own 62.8% of PolCard's outstanding equity, while the two funds managed by Innova own, in aggregate, 36.9% of PolCard's outstanding equity. The Polish Bank Association continues to own 0.3% of the outstanding equity of PolCard. We have a fair value option to purchase Innova's interest in PolCard, and Innova has the reciprocal right to sell its interest in PolCard to us at fair value, during the period commencing approximately four and ending approximately six years after closing. -9- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 2 - BUSINESS ACQUISITIONS (continued) EUROPRINT HOLDINGS LTD. On June 24, 2003, we exercised our option to acquire the remaining 20% of the equity of Europrint Holdings Ltd. ("Europrint") and its wholly owned subsidiaries, including Interactive Games International ("IGI"), for approximately $5.1 million. We acquired the initial 80% of the equity of Europrint in fiscal 1999 for a net cash purchase price of $21.6 million, including related acquisition costs. Europrint is a provider of media promotional games and IGI has pioneered the development of interactive, televised lottery games. INTERLOTT TECHNOLOGIES, INC. On September 18, 2003 (after the close of our fiscal 2004 second quarter), we completed the acquisition of Interlott Technologies, Inc. ("Interlott"), a provider of instant ticket vending machines for the worldwide lottery industry. Interlott shareholders were given the opportunity to elect to receive either $9.00 per share in cash or a number of shares of Holdings common stock having a value of $9.00, or a combination of both, subject to adjustment so that the aggregate consideration we paid was 48.5% in cash and 51.5% in Holdings common stock. The final exchange ratio of 0.2156 shares of Holdings common stock for every share of Interlott common stock was determined based on the average closing price of $41.74 for Holdings common stock, for the 20 trading day period commencing August 14, 2003 through September 11, 2003. The aggregate purchase price, including assumed debt, was $86.4 million as follows:
Aggregate purchase price -------------- (in millions) Cash ($9.00 per share of Interlott common stock) $ 28.2 Cash payment to cancel outstanding stock options relating to Interlott common stock 5.7 --------------- Cash purchase price $ 33.9 Issuance of approximately 717,000 shares of Holdings common stock 30.0 --------------- Total aggregate purchase price $ 63.9 Cash payment to settle Interlott debt 22.5 --------------- $ 86.4 ===============
All conditions to the closing of the acquisition were satisfied, including obtaining the approval of the transaction by Interlott shareholders, securing necessary regulatory consents, and satisfying certain other closing conditions. Approval of this transaction by our shareholders was not required. The PolCard, Europrint and Interlott acquisitions are individually and in the aggregate, not material to our consolidated financial statements and accordingly, pro forma financial information has not been presented. -10- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 3 - INVENTORIES
August 23, February 22, 2003 2003 ------------------ ----------------- (Dollars in thousands) Inventories consist of: Raw materials $ 5,184 $ 14,133 Work in progress 47,479 54,855 Finished goods 4,785 3,299 ------------------ ----------------- $ 57,448 $ 72,287 ================== =================
Inventories include amounts we manufacture or assemble for our long-term service contracts and amounts related to product sales contracts. Work in progress at August 23, 2003 and February 22, 2003, includes approximately $42.1 million and $51.3 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 $62.5 million and $52.4 million at August 23, 2003 and February 22, 2003, respectively. NOTE 4 - LICENSE FEE In May 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. This license fee has been capitalized, is included in Other Assets in our Consolidated Balance Sheet at August 23, 2003, and will be amortized as a reduction in service revenue on a straight-line basis over the 20-year term of the Master Contract. The Master Contract is part of a comprehensive economic development package that provides incentives for us to keep our world corporate headquarters and manufacturing operations in Rhode Island. One such incentive is a tax stabilization agreement that we entered into in July 2003 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 corporate 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. NOTE 5 - 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. -11- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 5 - PRODUCT WARRANTIES (continued) A summary of product warranty activity, which is included in Accrued Expenses in our Consolidated Balance Sheets, is as follows:
August 23, 2003 ------------------ (Dollars in thousands) Balance at beginning of fiscal period $ 437 Additional reserves 291 Charges incurred (40) ------------------ Balance at end of fiscal period $ 688 ==================
NOTE 6 - LONG-TERM DEBT
August 23, February 22, 2003 2003 ------------------ ----------------- (Dollars in thousands) Long-term debt consists of: 1.75% Convertible Debentures due 2021 $ 175,000 $ 175,000 7.87% Series B Senior Notes due 2007 95,000 95,000 Interest rate swaps 12,992 14,721 Other 12,416 9,359 ------------------ ----------------- 295,408 294,080 Less current portion 8,813 6,992 ------------------ ----------------- $ 286,595 $ 287,088 ================== =================
We have an unsecured revolving credit facility of $300 million expiring in June 2006 (the "Credit Facility"). There were no outstanding borrowings under the Credit Facility at August 23, 2003 or February 22, 2003. Up to $100 million of the Credit Facility may be used for the issuance of letters of credit. As of August 23, 2003, there was $290.3 million available for borrowing under the Credit Facility, after considering $9.7 million of letters of credit issued and outstanding. On August 7, 2003, we launched an offer to purchase up to $55 million of our 7.87% Series B Senior Notes due 2007 (the "Senior Notes"). The offer expired on August 27, 2003. In September 2003, after the close of our fiscal 2004 second quarter, we repurchased $5.0 million of the Senior Notes. The Senior Notes are unsecured and are guaranteed by Holdings and certain of our subsidiaries and interest on each series is payable semi-annually in arrears on May 15 and November 15 of each year. NOTE 7 - 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. -12- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 8 - 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 August 23, 2003:
Total potential commitments --------------- (in thousands) Performance bonds $ 176,672 Financial guarantees 7,571 All other bonds 8,285 --------------- $ 192,528 ===============
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 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, at August 23, 2003, we guaranteed $5.2 million principal amount of loans made by an unrelated commercial lender to LTSC. The loans have a maturity date of January 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. 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 principally included in Other Liabilities in our Consolidated Balance Sheets at August 23, 2003 and February 22, 2003. 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 August 23, 2003, deferred product gross profit and deferred service revenue totaled $4.1 million and $6.7 million, respectively. -13- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 8 - 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 August 23, 2003, was $2.4 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. GAMING ENTERTAINMENT (DELAWARE) L.L.C. We have a 50% interest in Gaming Entertainment (Delaware) L.L.C. ("GED"). GED is a joint venture between us and a subsidiary of Full House Resorts, Inc. ("FHRI"). Pursuant to a 1995 management agreement ("Agreement"), GED manages a casino for Harrington Raceway, Inc. ("Harrington") and in return receives a percentage of gross revenues and operating profits as defined in the Agreement. Along with FHRI, we guarantee the payment of all amounts due Harrington under the Agreement. Our guarantee expires on February 1, 2012 or upon expiration of the Delaware Horse Racing Redevelopment Act. The consideration we receive in exchange for the guarantee are the equity earnings from our joint venture with FHRI. NOTE 9 -- COMPREHENSIVE INCOME The components of comprehensive income are as follows:
Three Months Ended Six Months Ended -------------------------- ------------------------- August 23, August 24, August 23, August 24, 2003 2002 2003 2002 ------------ ------------ ----------- ----------- (Dollars in thousands) Net income $ 48,476 $ 38,207 $ 89,502 $ 67,248 Other comprehensive income (loss), net of tax Foreign currency translation (4,113) (8,448) 5,104 (5,907) Unrecognized net gain (loss) on derivative instruments 4,000 (597) (1,048) (1,272) Unrealized loss on investments (1) - (1) (72) ------------ ------------ ----------- ----------- Comprehensive income $ 48,362 $ 29,162 $ 93,557 $ 59,997 ============ ============ =========== ===========
-14- 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 Six Months Ended -------------------------- -------------------------- August 23, August 24, August 23, August 24, 2003 2002 2003 2002 ------------ ------------ ------------ ----------- (Dollars and shares in thousands, except per share amounts) Numerator: Net income (Numerator for basic earnings per share) $ 48,476 $ 38,207 $ 89,502 $ 67,248 Effect of dilutive securities: Interest expense on 1.75% Convertible Debentures 517 - 662 - ------------ ------------ ------------ ----------- Numerator for diluted earnings per share $ 48,993 $ 38,207 $ 90,164 $ 67,248 ============ ============ ============ =========== Denominator: Denominator for basic earnings per share - weighted- average shares 57,918 57,225 57,413 57,387 Effect of dilutive securities: 1.75% Convertible Debentures 6,364 - 3,951 - Employee stock options 1,484 981 1,526 1,269 Unvested restricted and stock bonus discount shares 142 93 104 107 ------------ ------------ ------------ ----------- Dilutive potential common shares 7,990 1,074 5,581 1,376 Denominator for diluted earnings per share - adjusted weighted-average shares and assumed conversions 65,908 58,299 62,994 58,763 ============ ============ ============ =========== Basic earnings per share $ .84 $ .67 $ 1.56 $ 1.17 ============ ============ ============ =========== Diluted earnings per share $ .74 $ .66 $ 1.43 $ 1.14 ============ ============ ============ ===========
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 63 trading days in the quarter ended August 23, 2003, and all 6.4 million shares were included in the computation of diluted earnings per share. For the quarter ended August 24, 2002, none of the 6.4 million shares were included in the computation of diluted earnings per share because, in accordance with their terms, the Debentures had not yet become convertible. The Debentures were convertible for 80 out of 127 trading days during the six month period ended August 23, 2003, and approximately 4 million shares were included in the computation of diluted earnings per share. For the six months ended August 24, 2002, none of the 6.4 million shares were included in the computation of diluted earnings per share because, in accordance with their terms, the Debentures had not yet become convertible. -15- 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 and certain expenses that are not deductible for income tax purposes. NOTE 12 - RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires the consolidation of a variable interest entity (as defined) by its primary beneficiary. Primary beneficiaries are those companies that are subject to a majority of the risk of loss or entitled to receive a majority of the variable interest entity's residual returns, or both. In determining whether it is the primary beneficiary of a variable interest entity, a company with a variable interest must also treat a variable interest held by the company's related parties in that same entity as its own interests. FIN 46 applies immediately to variable interest entities that are created after or for which control is obtained after January 31, 2003. For variable interest entities created prior to February 1, 2003, the provisions of FIN 46 would be applied in the fiscal quarter beginning after June 15, 2003 (our third quarter of fiscal 2004). However, on September 19, 2003, the FASB issued proposed Staff Position ("FSP") No. FIN 46-e, "Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, for Certain Interests Held by a Public Entity", for public comment. Under the proposed FSP, we would not need to apply the provisions of FIN 46 to interests held in a variable interest entity ("VIE"), or potential VIE, until our fiscal 2004 fourth quarter, if certain conditions are met. We have a 50% limited partnership interest in West Greenwich Technology Associates, L.P. (the "Partnership"), which owns our world headquarters facilities and leases them to us. The general partner of the Partnership is an unrelated third party. We currently account for the Partnership using the equity method of accounting. The FSP described above does not apply to the Partnership. As a result, beginning in the third quarter of fiscal 2004, which began on August 24, 2003, we will consolidate the Partnership in accordance with FIN 46. Accordingly, we will record our world headquarters facilities owned by the Partnership as an asset, and the Partnership's debt obligation as a liability in our consolidated financial statements. We expect the adoption of this interpretation to increase balance sheet assets and liabilities in the range of $27 million to $30 million and to result in a one-time, non-cash, pre-tax gain in the range of $4 million to $5 million, or $0.05 per diluted share, that will be recorded in Other Income in our consolidated financial statements. The pre-tax gain will be recorded in Other Income and not as a cumulative-effect adjustment because the gain is not material to our consolidated financial statements. We have certain investments for which the applicability of FIN 46 has not yet been determined. The adoption of FIN 46's provisions, if applicable to such investments, is not expected to have a material impact on our financial statements. Pursuant to the proposed FSP noted above, if applicable, we would not be required to apply FIN 46 to these investments until our fiscal 2004 fourth quarter. In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS 149 amends Statement of Financial Accounting Standards No. 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires that contracts with similar characteristics be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. We do not expect this statement to have a material impact on our consolidated financial statements. In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The provisions of SFAS 150 are effective for financial instruments entered into or modified after May 31, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15, 2003 (our third quarter of fiscal 2004). We do not expect this statement to have a material impact on our consolidated financial statements. -16- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION On December 18, 2001, Holdings (the "Parent Company") issued $175 million principal amount of 1.75% Convertible Debentures due 2021 (the "Convertible Debentures"). The Convertible Debentures 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 revenue 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. -17- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Balance Sheets August 23, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated --------------- ------------- --------------- ------------- -------------- (Dollars in thousands) Assets Current Assets: Cash and cash equivalents $ - $ 52,443 $ 41,879 $ - $ 94,322 Trade accounts receivable, net - 68,400 38,164 - 106,564 Due from subsidiaries and affiliates - 48,005 - (48,005) - Sales-type lease receivables - 1,074 3,139 - 4,213 Inventories - 43,144 19,665 (5,361) 57,448 Deferred income taxes - 25,599 3,811 - 29,410 Other current assets - 13,029 15,820 - 28,849 --------------- ------------- --------------- ------------- -------------- Total Current Assets - 251,694 122,478 (53,366) 320,806 Systems, Equipment and Other Assets Relating to Contracts, net - 430,856 78,409 (4,917) 504,348 Investment in Subsidiaries and Affiliates 433,625 134,981 - (568,606) - Goodwill, net - 70,605 76,390 - 146,995 Other Assets - 65,321 32,541 - 97,862 --------------- ------------- --------------- ------------- -------------- Total Assets $ 433,625 $ 953,457 $ 309,818 $ (626,889) $ 1,070,011 =============== ============= =============== ============= ============== Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ - $ 40,750 $ 22,625 $ - $ 63,375 Due to subsidiaries and affiliates - - 48,005 (48,005) - Accrued expenses - 33,910 19,655 - 53,565 Employee compensation - 23,293 5,042 - 28,335 Advance payments from customers - 36,534 25,974 - 62,508 Deferred revenue and advance billings - 9,906 2,748 - 12,654 Income taxes payable - 45,874 4,244 - 50,118 Taxes other than income tax - 11,786 13,476 - 25,262 Short term borrowings - - 2,219 - 2,219 Current portion of long-term debt - 3,524 5,289 - 8,813 -------------- ------------- --------------- ------------- -------------- Total Current Liabilities - 205,577 149,277 (48,005) 306,849 Long-Term Debt, less current portion - 279,468 7,127 - 286,595 Other Liabilities - 24,509 18,433 - 42,942 Shareholders' Equity 433,625 443,903 134,981 (578,884) 433,625 --------------- ------------- --------------- ------------- -------------- Total Liabilities and Shareholders' Equity $ 433,625 $ 953,457 $ 309,818 $ (626,889) $ 1,070,011 =============== ============= =============== ============= ==============
-18- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Income Statements Three Months Ended August 23, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated --------------- ------------- --------------- ------------- -------------- (Dollars in thousands) Revenues: Services $ - $ 172,895 $ 65,124 $ - $ 238,019 Sales of products - 8,469 30,759 - 39,228 Intercompany sales and fees - 18,495 11,628 (30,123) - --------------- ------------- --------------- ------------- -------------- - 199,859 107,511 (30,123) 277,247 Costs and expenses: Costs of services - 92,010 41,796 (1,001) 132,805 Costs of sales - 3,694 25,150 (34) 28,810 Intercompany cost of sales and fees - 38,634 3,906 (42,540) - --------------- ------------- --------------- ------------- -------------- - 134,338 70,852 (43,575) 161,615 --------------- ------------- --------------- ------------- -------------- Gross profit - 65,521 36,659 13,452 115,632 Selling, general and administrative - 17,653 9,398 - 27,051 Research and development - 9,131 4,975 - 14,106 --------------- ------------- --------------- ------------- -------------- Operating expenses - 26,784 14,373 - 41,157 --------------- ------------- --------------- ------------- -------------- Operating income - 38,737 22,286 13,452 74,475 Other income (expense): Interest income - 201 820 - 1,021 Equity in earnings of unconsolidated affiliates - 1,381 1,310 - 2,691 Equity in earnings of consolidated affiliates 48,476 15,035 - (63,511) - Other income (expense) - 711 (246) - 465 Interest expense - (1,399) (306) - (1,705) --------------- ------------- --------------- -------------- -------------- Income before income taxes 48,476 54,666 23,864 (50,059) 76,947 Income taxes - 20,226 8,829 (584) 28,471 --------------- ------------- --------------- ------------- -------------- Net income $ 48,476 $ 34,440 $ 15,035 $ (49,475) $ 48,476 =============== ============= =============== ============= ==============
-19- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Income Statements Six Months Ended August 23, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------------- ------------- --------------- ------------- ------------ (Dollars in thousands) Revenues: Services $ - $ 339,198 $ 122,359 $ - $ 461,557 Sales of products - 20,085 35,190 - 55,275 Intercompany sales and fees - 45,342 21,933 (67,275) - -------------- ------------- --------------- ------------- -------------- - 404,625 179,482 (67,275) 516,832 Costs and expenses: Costs of services - 182,031 79,618 (2,047) 259,602 Costs of sales - 9,981 27,512 (54) 37,439 Intercompany cost of sales and fees - 54,604 8,552 (63,156) - -------------- ------------- --------------- ------------- -------------- - 246,616 115,682 (65,257) 297,041 -------------- ------------- --------------- ------------- -------------- Gross profit - 158,009 63,800 (2,018) 219,791 Selling, general and administrative - 35,686 15,645 - 51,331 Research and development - 19,815 8,681 - 28,496 -------------- ------------- --------------- ------------- -------------- Operating expenses - 55,501 24,326 - 79,827 -------------- ------------- --------------- ------------- -------------- Operating income - 102,508 39,474 (2,018) 139,964 Other income (expense): Interest income - 560 1,649 - 2,209 Equity in earnings of unconsolidated affiliates - 2,571 2,049 - 4,620 Equity in earnings of consolidated affiliates 89,502 24,513 - (114,015) - Other income (expense) - 2,729 (3,444) - (715) Interest expense - (3,192) (819) - (4,011) -------------- ------------- --------------- ------------- -------------- Income before income taxes 89,502 129,689 38,909 (116,033) 142,067 Income taxes - 47,985 14,396 (9,816) 52,565 -------------- ------------- --------------- ------------- -------------- Net income $ 89,502 $ 81,704 $ 24,513 $ (106,217) $ 89,502 ============== ============= =============== ============= ==============
-20- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Income Statements Three Months Ended August 24, 2002
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------------- ------------- --------------- ------------- -------------- (Dollars in thousands) Revenues: Services $ - $ 159,070 $ 52,530 $ - $ 211,600 Sales of products - 5,465 3,893 - 9,358 Intercompany sales and fees - 29,461 12,423 (41,884) - -------------- ------------- --------------- ------------- -------------- - 193,996 68,846 (41,884) 220,958 Costs and expenses: Costs of services - 90,031 40,180 (3,269) 126,942 Costs of sales - 2,007 2,417 (315) 4,109 Intercompany cost of sales and fees - 14,443 5,195 (19,638) - -------------- ------------- --------------- ------------- -------------- - 106,481 47,792 (23,222) 131,051 -------------- ------------- --------------- ------------- -------------- Gross profit - 87,515 21,054 (18,662) 89,907 Selling, general and administrative - 17,058 5,843 - 22,901 Research and development - 5,351 1,819 - 7,170 -------------- ------------- --------------- ------------- -------------- Operating expenses - 22,409 7,662 - 30,071 -------------- ------------- --------------- ------------- -------------- Operating income - 65,106 13,392 (18,662) 59,836 Other income (expense): Interest income - 395 582 - 977 Equity in earnings of unconsolidated affiliates - 220 1,041 - 1,261 Equity in earnings of consolidated affiliates 38,207 11,144 - (49,351) - Other income (expense) - (1,166) 3,435 - 2,269 Interest expense - (2,242) (476) - (2,718) -------------- ------------- --------------- ------------- -------------- Income before income taxes 38,207 73,457 17,974 (68,013) 61,625 Income taxes - 27,914 6,831 (11,327) 23,418 -------------- ------------- --------------- ------------- -------------- Net income $ 38,207 $ 45,543 $ 11,143 $ (56,686) $ 38,207 ============== ============= =============== ============= ==============
-21- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Income Statements Six Months Ended August 24, 2002
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------------- ------------- --------------- ------------- ------------ (Dollars in thousands) Revenues: Services $ - $ 331,153 $ 104,182 $ - $ 435,335 Sales of products - 10,135 6,900 - 17,035 Intercompany sales and fees - 48,784 24,910 (73,694) - -------------- ------------- --------------- ------------- -------------- - 390,072 135,992 (73,694) 452,370 Costs and expenses: Costs of services - 194,254 85,039 (5,416) 273,877 Costs of sales - 5,856 4,815 (315) 10,356 Intercompany cost of sales and fees - 28,784 7,287 (36,071) - -------------- ------------- --------------- ------------- -------------- - 228,894 97,141 (41,802) 284,233 -------------- ------------- --------------- ------------- -------------- Gross profit - 161,178 38,851 (31,892) 168,137 Selling, general and administrative - 34,557 11,253 - 45,810 Research and development - 10,317 3,355 - 13,672 -------------- ------------- --------------- ------------- -------------- Operating expenses - 44,874 14,608 - 59,482 -------------- ------------- --------------- ------------- -------------- Operating income - 116,304 24,243 (31,892) 108,655 Other income (expense): Interest income - 749 1,070 - 1,819 Equity in earnings of unconsolidated affiliates - 296 1,661 - 1,957 Equity in earnings of consolidated affiliates 67,248 18,230 - (85,478) - Other income (expense) - (1,671) 3,349 - 1,678 Interest expense - (4,724) (919) - (5,643) -------------- ------------- --------------- ------------- -------------- Income before income taxes 67,248 129,184 29,404 (117,370) 108,466 Income taxes - 49,090 11,174 (19,046) 41,218 -------------- ------------- --------------- ------------- -------------- Net income $ 67,248 $ 80,094 $ 18,230 $ (98,324) $ 67,248 ============== ============= =============== ============= ==============
-22- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Statements of Cash Flows Six Months Ended August 23, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated ----------- ------------- --------------- ------------- -------------- (Dollars in thousands) Net cash provided by operating activities $ - $ 109,427 $ 61,340 $ (313) $ 170,454 Investing Activities Purchases of systems, equipment and other assets relating to contracts - (137,541) (6,546) 313 (143,774) Acquisitions (net of cash acquired) - - (41,023) - (41,023) License fee - (12,500) - - (12,500) Investments in and advances to unconsolidated subsidiaries - (1,185) - - (1,185) Other - (6,285) - - (6,285) ----------- ------------- --------------- ------------- -------------- Net cash used for investing activities - (157,511) (47,569) 313 (204,767) Financing Activities Net proceeds from issuance of long-term debt - - 1,409 - 1,409 Principal payments on long-term debt - - (2,146) - (2,146) Proceeds from stock options 21,101 - - - 21,101 Dividends paid (9,883) - - - (9,883) Intercompany capital transactions (11,688) 11,688 - - - Other 470 - (954) - (484) ----------- ------------- ---------------- ------------- -------------- Net cash provided by (used for) financing activities - 11,688 (1,691) - 9,997 Effect of exchange rate changes on cash - 100 2,364 - 2,464 ----------- ------------- --------------- ------------- -------------- Increase (decrease) in cash and cash equivalents - (36,296) 14,444 - (21,852) Cash and cash equivalents at beginning of period - 88,739 27,435 - 116,174 ----------- ------------- --------------- ------------- -------------- Cash and cash equivalents at end of period $ - $ 52,443 $ 41,879 $ - $ 94,322 =========== ============= =============== ============= ==============
-23- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 13 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued) Condensed Consolidating Statements of Cash Flows Six Months Ended August 24, 2002
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated ----------- ------------- --------------- ------------- -------------- (Dollars in thousands) Net cash provided by operating activities $ - $ 189,637 $ 9,849 $ 167 $ 199,653 Investing Activities Purchases of systems, equipment and other assets relating to contracts - (82,259) (5,969) (167) (88,395) Other - (2,950) - - (2,950) ----------- ------------- --------------- ------------- -------------- Net cash used for investing activities - (85,209) (5,969) (167) (91,345) Financing Activities Principal payments on long-term debt - (2,186) (1,430) - (3,616) Purchases of treasury stock (42,453) - - - (42,453) Proceeds from stock options 14,331 - - - 14,331 Intercompany capital transactions 27,647 (27,647) - - - Other 475 (120) 1,149 - 1,504 ----------- ------------- --------------- ------------- -------------- Net cash used for financing activities - (29,953) (281) - (30,234) Effect of exchange rate changes on cash - (1,428) 3,165 - 1,737 ----------- ------------- --------------- ------------- -------------- Increase in cash and cash equivalents - 73,047 6,764 - 79,811 Cash and cash equivalents at beginning of period - 25,865 9,230 - 35,095 ----------- ------------- --------------- ------------- -------------- Cash and cash equivalents at end of period $ - $ 98,912 $ 15,994 $ - $ 114,906 =========== ============= =============== ============= ==============
-24- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 14 - SUBSEQUENT EVENTS INTERLOTT TECHNOLOGIES, INC. On September 18, 2003 (after the close of our fiscal 2004 second quarter), we completed the acquisition of Interlott Technologies, Inc. ("Interlott"), a provider of instant ticket vending machines for the worldwide lottery industry. See Note 2 "Business Acquisitions" for detailed disclosures. -25- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The terms "Holdings", "the Company", "we", "our" and "us" refer to GTECH Holdings Corporation and its consolidated subsidiaries, unless otherwise specified. 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 may 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 (including, without limitation, expected future growth in revenues, profit margins and earnings per share); - our ability to retain existing contracts and to obtain and retain new contracts; - the future performance of comparable investment opportunities; and - the results and effects of legal proceedings and investigations. 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 the following: - government regulations and other actions affecting the online lottery industry could have a negative effect on our business and sales; - 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 and other transaction processing services could lead to lower revenues and net income; - 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 derive close to half of our revenues from foreign jurisdictions (including over ten percent from Brazilian operations) and are subject to the economic, political and social instability risks of doing business in foreign jurisdictions; - we have a concentrated customer base and the loss of any of these customers (or lower sales from any of these customers) could lead to lower revenues; - 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 net income or to lose contracts; - we are subject to substantial penalties for failure to perform under our contracts; - we may not be able to respond in a timely manner to technological changes or to satisfy future technology demands of our customers, in which case we may 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 new or existing markets to the detriment of our business; - our business prospects and future success depend upon our ability to attract and retain qualified employees; -26- - 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; - we may not be able to successfully integrate the operations of companies that we acquire into our business, and may thereby fail to realize the strategic and financial benefits that we had expected from such acquisitions; - we may be subject to adverse determinations in pending legal proceedings, which could involve substantial monetary judgments or reputational damage; and - other risks and uncertainties set forth below and elsewhere in this report, in our fiscal 2003 Form 10-K, as amended, 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. General We operate on a 52 to 53-week fiscal year ending on the last Saturday in February and fiscal 2004 ends on February 28, 2004. Fiscal 2004 is a 53-week year and we will include the extra week in our fourth quarter ending February 28, 2004. 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 lottery sales. These percentages vary depending on the size of the lottery and the scope of services provided to the lottery. We derive product sale revenues primarily 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. The size and timing of these transactions have resulted in variability in product sale revenues from period to period. Including the acquisition of Interlott Technologies, Inc. described below, we currently anticipate that product sales during fiscal 2004 will be in the range of $120 million to $130 million. 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, Chile, the Czech Republic and Jamaica process bill payments and other commercial service transactions. In addition, in May 2003 we acquired PolCard, the largest debit and credit card merchant transaction acquirer and processor in Poland. In the near term, we expect to concentrate our efforts to grow commercial service revenues in Brazil, Poland and Mexico. 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 see a chance to gain access to certain markets through the acquisition of existing businesses, we may consider making such acquisitions. -27- 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; - "Legal Proceedings" in Part II, Item 1 in our Quarterly Report for the quarterly period ended May 24, 2003; - 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" in our fiscal 2003 Annual Report on Form 10-K, as amended; - Part I, Item 3 - "Legal Proceedings" in our fiscal 2003 Annual Report on Form 10-K, as amended; - Note 11 to the Consolidated Financial Statements in our fiscal 2003 Annual Report on Form 10-K, as amended We are a global business and we derive a substantial portion of our revenues from operations outside of the United States. In particular, in fiscal 2003, we derived 49.2% of our revenues from international operations and 10.3% of our revenues from our Brazilian operations alone (including 9.8% of our revenues from Caixa Economica Federal, the operator of Brazil's National Lottery, which was our largest customer in fiscal 2003 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. Significant Contract Bids and Extensions A majority of our revenues and cash flow is derived from our portfolio of long-term online lottery service contracts, each of which in the ordinary course of our business is periodically the subject of competitive procurement or renegotiation. In the second quarter of fiscal 2004, we continued to execute against our growth strategy by signing new contracts and contract extensions both domestically and abroad. As previously reported, in April 2003, we entered into an agreement with Caixa Economica Federal ("CEF"), the operator of Brazil's National Lottery, pursuant to which the term of our contract with CEF, which had been scheduled to expire in April 2003, was extended for 25 months from April 2003 (with CEF having the right to elect upon prior notice to terminate the contract early at any time after 20 months), and fees payable under our contract are reduced by 15%. Our previous contract with CEF, which as extended, expired in April 2003, was our largest contract in fiscal 2003, as measured by annual revenues, accounting for 9.8% of our consolidated revenues. See Part I, Item 3 - "Legal Proceedings" and Note 11 to the Consolidated Financial Statements in our fiscal 2003 Annual Report on Form 10-K, as amended, for further information concerning this matter. -28- In May 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. This license fee has been capitalized, is included in Other Assets in our Consolidated Balance Sheet at August 23, 2003, and will be amortized as a reduction in service revenue on a straight-line basis over the 20-year term of the Master Contract. The Master Contract is part of a comprehensive economic development package that provides incentives for us to keep our world corporate headquarters and manufacturing operations in Rhode Island. One such incentive is a tax stabilization agreement that we entered into in July 2003 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 corporate 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 2003, we were awarded a new five-year integrated services contract by the Wisconsin Lottery to provide a fully integrated online and instant ticket gaming system, and Internet Protocol-based wireless telecommunications network. In July 2003, we signed a contract with The National Lotteries Control Board and The Betting Levy Board of Trinidad and Tobago to provide a complete video lottery solution, including a central system, video lottery terminals and communications network, for a five-year period that is expected to commence in April 2004 and includes a two-year extension option. In September 2003 (after the close of our fiscal 2004 second quarter), following a public, competitive procurement, we were selected by the Florida Lottery as the apparent successful bidder to supply a new online lottery system, lottery terminals, and related telecommunications network. The proposed six-year integrated services contract is expected to commence on February 1, 2005 and includes two, two-year extension options. During the second quarter of fiscal 2004, the Michigan Lottery signed a three-year contract extension with us and exercised an option in its existing contract with us for Club Keno. Additionally, we extended our relationship with lottery customers in Turkey, New Zealand, Sweden and the Idaho Department of Fish and Game. In August 2003, following a competitive procurement, the Nebraska lottery authority selected another vendor to provide equipment and services for a new online lottery gaming system upon the scheduled expiration of our current contract with the Nebraska Lottery in June 2004, however, we will remain as the Nebraska Lottery's instant-ticket products and system supplier through June 2008. Over the past several fiscal years, contract renewal and extension rates in the United States have generally been lower than existing contract rates due to a number of factors, including the substantial growth of lottery sales during the latter part of the 1990's and calendar year 2002, 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 GTECH 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. -29- Recent Developments POLCARD S.A. On May 28, 2003, we completed the acquisition of a controlling equity position in PolCard S.A. ("PolCard"), for a purchase price, net of cash acquired, of $35.9 million. PolCard is the largest debit and credit card merchant transaction acquirer and processor in Poland. At August 23, 2003, PolCard's outstanding equity was owned 66.5% by us, 33.2% by two funds managed by Innova Capital Sp. zo.o ("Innova"), a Warsaw-based private equity investment advisor, and 0.3% by the Polish Bank Association, one of PolCard's previous owners. In September 2003 (after the close of our fiscal 2004 second quarter), Innova exercised its rights under an option agreement to purchase from us, 3.7% of PolCard's equity for a purchase price of $2.3 million. Following the exercise of this right, we now own 62.8% of PolCard's outstanding equity, while the two funds managed by Innova own, in aggregate, 36.9% of PolCard's outstanding equity. The Polish Bank Association continues to own 0.3% of the outstanding equity of PolCard. We have a fair value option to purchase Innova's interest in PolCard, and Innova has the reciprocal right to sell its interest in PolCard to us at fair value, during the period commencing approximately four and ending approximately six years after closing. EUROPRINT HOLDINGS LTD. On June 24, 2003, we exercised our option to acquire the remaining 20% of the equity of Europrint Holdings Ltd. ("Europrint") and its wholly owned subsidiaries, including Interactive Games International ("IGI"), for approximately $5.1 million. We acquired the initial 80% of the equity of Europrint during fiscal 1999 for a net cash purchase price of $21.6 million, including related acquisition costs. Europrint is a provider of media promotional games and IGI has pioneered the development of interactive, televised lottery games. DIVIDEND On July 31, 2003, we paid our first quarterly cash dividend of $0.17 per share to shareholders of record as of July 15, 2003, for a total of $9.9 million. Subsequent Events INTERLOTT TECHNOLOGIES, INC. On September 18, 2003 (after the close of our fiscal 2004 second quarter), we completed the acquisition of Interlott Technologies, Inc. ("Interlott"), a provider of instant ticket vending machines for the worldwide lottery industry. Interlott shareholders were given the opportunity to elect to receive either $9.00 per share in cash or a number of shares of Holdings common stock having a value of $9.00, or a combination of both, subject to adjustment so that the aggregate consideration we paid was 48.5% in cash and 51.5% in Holdings common stock. The final exchange ratio of 0.2156 shares of Holdings common stock for every share of Interlott common stock was determined based on the average closing price of $41.74 for Holdings common stock, for the 20 trading day period commencing August 14, 2003 through September 11, 2003. The aggregate purchase price, including assumed debt, was $86.4 million as follows:
Aggregate purchase price -------------- (in millions) Cash ($9.00 per share of Interlott common stock) $ 28.2 Cash payment to cancel outstanding stock options relating to Interlott common stock 5.7 -------------- Cash purchase price $ 33.9 Issuance of approximately 717,000 shares of Holdings common stock 30.0 -------------- Total aggregate purchase price $ 63.9 Cash payment to settle Interlott debt 22.5 -------------- $ 86.4 ==============
-30- All conditions to the closing of the acquisition were satisfied, including obtaining the approval of the transaction by Interlott shareholders, securing necessary regulatory consents, and satisfying certain other closing conditions. Approval of this transaction by our shareholders was not required. Critical Accounting Policies We have identified the accounting policies listed below that we believe are most critical to our financial condition and results of operations, and that require management's most difficult, subjective and complex judgments in estimating the effect of inherent uncertainties. This section should be read in conjunction with Note 1 to our Consolidated Financial Statements included in our fiscal 2003 Annual Report on Form 10-K, as amended, which includes other significant accounting policies. REVENUE RECOGNITION Amounts received from customers in advance of revenue recognition are recorded in Advance Payments from Customers in our Consolidated Balance Sheets. We record liquidated damages (which equaled 0.47%, 0.14% and 0.47% of our total revenues in fiscal 2003, 2002 and 2001, respectively) as a reduction of revenue in the period they become probable and estimable. Service revenues from commercial transaction processing services are recorded based on the net amount retained, which is the amount billed to our customer less the amount paid to our suppliers, in accordance with Emerging Issues Task Force Issue No. 99-19, "Reporting Revenue Gross as a Principal Versus Net as an Agent". We generally conduct business under one of three types of contractual arrangements: Product Sales Contracts, Operating Contracts and Facilities Management Contracts. PRODUCT SALES CONTRACTS Under Product Sales Contracts, we construct, sell, deliver and install a turnkey online lottery system ("lottery system") or lottery equipment and license the computer software for a fixed price, and the lottery authority subsequently operates the lottery system. Because Product Sales Contracts include significant customization and modification and other services prior to customer acceptance that are considered essential to the lottery software inherent in our lottery systems, revenue is recognized using contract accounting. Under contract accounting, amounts due to us, and costs incurred by us in constructing the lottery system, prior to customer acceptance, are deferred. Revenue attributable to the lottery system is recognized upon customer acceptance as long as there are no substantial doubts regarding collectibility (the completed contract method of accounting). In certain Product Sale Contracts (primarily the stand-alone sale of lottery terminals), we are not responsible for installation. In these cases, we recognize revenue when the four basic revenue recognition criteria of SEC Staff Accounting Bulletin 101 have been met. 1. Persuasive evidence of an arrangement exists - Revenue is only recognized if a signed contract or legally enforceable purchase order is obtained. 2. Delivery has occurred or services have been rendered - Revenue is only recognized if appropriate evidence of delivery is obtained and once any customer acceptance criteria have been met. 3. The seller's price to the buyer is fixed or determinable - Revenue is only recognized if the sales price is fixed and determinable in the signed contract or legally enforceable purchase order. -31- 4. Collectibility is reasonably assured - Revenue is only recognized when there are no significant doubts regarding the collectibility of the amounts due from the customer. Revenues received under Product Sale Contracts are classified as Sales of Products in our Consolidated Income Statements. OPERATING CONTRACTS Under Operating Contracts, we generally construct, install and operate the lottery system, but sell and transfer full title and interest in the lottery system to the customer for a fixed fee. Fees paid to us for ongoing services and the licensing of the computer software are generally variable and are based on a percentage of a lottery's gross online and instant lottery sales. Because Operating Contracts include significant customization and modification and other services prior to customer acceptance that are considered essential to the lottery software inherent in our lottery systems, revenue is recognized using contract accounting. Under contract accounting, amounts due to us, and costs incurred by us in constructing the lottery system, prior to customer acceptance, are deferred. Revenue attributable to the lottery system is recognized upon customer acceptance as long as there are no substantial doubts regarding collectibility (the completed contract method of accounting) and are classified as Sales of Products in our Consolidated Income Statements. Ongoing service and license fees are recognized as revenue in the period earned and are classified as Service Revenue in our Consolidated Income Statements. We have not entered into any new Operating Contracts in the last three fiscal years. Additionally, Operating Contract revenue accounted for less than 2% of our consolidated revenue during fiscal 2003. These types of contractual arrangements have diminished in importance and we expect similar levels of revenue in the future. FACILITIES MANAGEMENT CONTRACTS Under typical Facilities Management Contracts, we construct, install and operate the lottery system, and retain ownership of the lottery system. These contracts generally provide for a variable amount of monthly or weekly service fees paid to us directly from the lottery authority based on a percentage of a lottery's gross online and instant lottery sales. These fees are recognized as revenue in the period earned and are classified as Service Revenue in our Consolidated Income Statements. RECEIVABLES AND INVENTORY RESERVES We evaluate the collectibility of trade accounts and sales-type lease receivables on a customer-by-customer basis and we believe our reserves are adequate; however, if economic circumstances change significantly resulting in a major customer's inability or unwillingness to meet its financial obligations to us, original estimates of the recoverability of amounts due to us could be reduced by significant amounts requiring additional reserves. Inventories are stated at the lower of cost (first-in, first-out method) or market. Inventories include amounts related to products we manufacture or assemble for our long-term service contracts, which are transferred to Systems, Equipment and Other Assets Relating to Contracts in our Consolidated Balance Sheets upon shipment. Inventories also include amounts related to product sales contracts, including product sales under long-term contracts. We regularly review inventory quantities on hand and record provisions for potentially obsolete or slow-moving inventory based primarily on our estimated forecast of product demand and production requirements. We believe our reserves are adequate; however, should future sales forecasts change, our original estimates of obsolescence could increase by a significant amount requiring additional reserves. -32- IMPAIRMENT OF GOODWILL We perform a test for the impairment of goodwill annually, or more frequently if events or circumstances indicate that goodwill may be impaired. Because we have a single operating and reportable business segment (the Transaction Processing Segment), we perform this test by comparing the fair value of the Transaction Processing Segment with its book value, including goodwill. If the fair value of the Transaction Processing Segment exceeds its book value, goodwill is not impaired. If the book value exceeds the fair value, we would calculate the potential impairment loss by comparing the implied fair value of goodwill with the book value. If the implied goodwill is less than the book value, a write-down would be recorded. IMPAIRMENT OF LONG-LIVED ASSETS We periodically evaluate the recoverability of long-lived assets whenever indicators of impairment are present. Indicators of impairment include such items as declines in revenues and earnings or cash flows or material adverse changes in the economic or political stability of a particular country, which may indicate that the carrying amount of an asset is not recoverable. If facts and circumstances indicate that our long-lived assets may be impaired, the estimated future undiscounted cash flows associated with these long-lived assets would be compared to their carrying amounts to determine if a write-down to fair value is necessary. Effect of Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires the consolidation of a variable interest entity (as defined) by its primary beneficiary. Primary beneficiaries are those companies that are subject to a majority of the risk of loss or entitled to receive a majority of the variable interest entity's residual returns, or both. In determining whether it is the primary beneficiary of a variable interest entity, a company with a variable interest must also treat a variable interest held by the company's related parties in that same entity as its own interests. FIN 46 applies immediately to variable interest entities that are created after or for which control is obtained after January 31, 2003. For variable interest entities created prior to February 1, 2003, the provisions of FIN 46 would be applied in the fiscal quarter beginning after June 15, 2003 (our third quarter of fiscal 2004). However, on September 19, 2003, the FASB issued proposed Staff Position ("FSP") No. FIN 46-e, "Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, for Certain Interests Held by a Public Entity", for public comment. Under the proposed FSP, we would not need to apply the provisions of FIN 46 to interests held in a variable interest entity ("VIE"), or potential VIE, until our fiscal 2004 fourth quarter, if certain conditions are met. We have a 50% limited partnership interest in West Greenwich Technology Associates, L.P. (the "Partnership"), which owns our world headquarters facilities and leases them to us. The general partner of the Partnership is an unrelated third party. We currently account for the Partnership using the equity method of accounting. The FSP described above does not apply to the Partnership. As a result, beginning in the third quarter of fiscal 2004, which began on August 24, 2003, we will consolidate the Partnership in accordance with FIN 46. Accordingly, we will record our world headquarters facilities owned by the Partnership as an asset, and the Partnership's debt obligation as a liability in our consolidated financial statements. We expect the adoption of this interpretation to increase balance sheet assets and liabilities in the range of $27 million to $30 million and to result in a one-time, non-cash, pre-tax gain in the range of $4 million to $5 million, or $0.05 per diluted share, that will be recorded in Other Income in our consolidated financial statements. The pre-tax gain will be recorded in Other Income and not as a cumulative-effect adjustment because the gain is not material to our consolidated financial statements. We have certain investments for which the applicability of FIN 46 has not yet been determined. The adoption of FIN 46's provisions, if applicable to such investments, is not expected to have a material impact on our financial statements. Pursuant to the proposed FSP noted above, if applicable, we would not be required to apply FIN 46 to these investments until our fiscal 2004 fourth quarter. -33- In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS 149 amends Statement of Financial Accounting Standards No. 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires that contracts with similar characteristics be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. We do not expect this statement to have a material impact on our consolidated financial statements. In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The provisions of SFAS 150 are effective for financial instruments entered into or modified after May 31, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15, 2003 (our third quarter of fiscal 2004). We do not expect this statement to have a material impact on our consolidated financial statements. Results of Operations THREE MONTHS ENDED AUGUST 23, 2003 VERSUS THREE MONTHS ENDED AUGUST 24, 2002 Revenues were $277.2 million in the second quarter of fiscal 2004, compared to $221.0 million in the second quarter of fiscal 2003, up $56.2 million, or 25.5%. The following discussion on service revenues should be read in conjunction with the table below (in millions):
Three Months Ended ------------------------------------------------------- Change August 23, August 24, ------------------- Service revenues 2003 2002 $ % - ---------------- ------------ ------------ --------- ------ Domestic lottery $ 130.1 $ 121.0 $ 9.1 7.5 International lottery 87.7 77.5 10.2 13.2 Commercial services 19.5 12.5 7.0 56.7 All other 0.7 0.6 0.1 5.5 ------------ ------------ --------- ------ $ 238.0 $ 211.6 $ 26.4 12.5 ============ ============ ========= ======
Our domestic lottery service revenues were $130.1 million in the second quarter of fiscal 2004, compared to $121.0 million in the second quarter of fiscal 2003, up $9.1 million, or 7.5%. This 7.5% increase was primarily due to higher service revenues of approximately 5% from an increase in sales by our domestic lottery customers, with the balance of the increase due to the combined effect of higher jackpot activity and new contracts, net of contractual rate changes and penalties. 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. Our international lottery service revenues grew to $87.7 million in the second quarter of fiscal 2004, from $77.5 million in the second quarter of fiscal 2003, up $10.2 million, or 13.2%. This 13.2% increase includes higher service revenues of approximately 11% from an increase in sales by our international lottery customers and approximately 2% from the strengthening of most major currencies against the U.S. dollar, particularly the Brazilian real, British pound, Czech koruna and the South African rand. -34- 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 and the successful introduction of new games. Service revenues from commercial transaction processing services were $19.5 million in the second quarter of fiscal 2004, compared to $12.5 million in the second quarter of fiscal 2003, up $7.0 million, or 56.7%, primarily due to the acquisition of PolCard. Product sales were $39.2 million in the second quarter of fiscal 2004, compared to $9.4 million in the second quarter of fiscal 2003. This $29.8 million increase was primarily driven by the sale of our new interactive, web-based software application, ES Interactive, to our customer in the United Kingdom. Our service margins improved from 40.0% in the second quarter of fiscal 2003 to 44.2% in the second quarter of fiscal 2004, primarily due to lower depreciation of approximately 3 percentage points, principally related to fully depreciated assets associated with our contract with Caixa Economica Federal in Brazil. Our product margins fluctuate depending on the mix, volume and timing of product sales contracts. Our product margins were 26.6% in the second quarter of fiscal 2004 compared to 56.1% in the second quarter of fiscal 2003. This change was primarily due to the different mix of sales, with a high volume of higher margin equipment sales recorded in the second quarter of fiscal 2003. Operating expenses were $41.2 million in the second quarter of fiscal 2004, compared to $30.1 million in the second quarter of fiscal 2003, up $11.1 million, or 36.9%. This increase was driven by $6.9 million of increased spending on research and development as we continue our efforts to accelerate the development and deployment of industry-leading products into the marketplace and to execute against our commercial services strategy. In addition, selling, general and administrative expense was up $4.2 million, primarily driven by business development activities in Poland and Mexico, increased marketing expenses primarily associated with trade shows and conferences, and the acquisition of PolCard. As a percentage of revenues, operating expenses were 14.8% and 13.6% during the second quarters of fiscal 2004 and 2003, respectively. Weighted average diluted shares in the second quarter of fiscal 2004 increased by 7.6 million shares to 65.9 million shares, primarily due to the convertibility during the second quarter of our $175 million principal amount of 1.75% Convertible Debentures into shares of our common stock, resulting in a decrease to diluted earnings per share of approximately $0.07. 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 63 trading days in the second quarter of fiscal 2004, and accordingly, all 6.4 million shares were included in the computation of diluted earnings per share. Our effective income tax rate decreased from 38% in the second quarter of fiscal 2003 to 37% in the second quarter of fiscal 2004 principally due to a larger percentage of international profits taxed at rates that are lower than the U.S. statutory tax rate and the increased recognition of research and development tax credits. -35- SIX MONTHS ENDED AUGUST 23, 2003 VERSUS SIX MONTHS ENDED AUGUST 24, 2002 Revenues were $516.8 million in the first six months of fiscal 2004, compared to $452.4 million in the first six months of fiscal 2003, up $64.5 million, or 14.2%. The following discussion on service revenues should be read in conjunction with the table below (in millions):
Six Months Ended ------------------------------------------------------- Change August 23, August 24, ------------------- Service revenues 2003 2002 $ % - ---------------- ------------ ------------ --------- ------ Domestic lottery $ 254.9 $ 246.9 $ 8.0 3.2 International lottery 173.8 159.9 13.9 8.7 Commercial services 31.5 27.2 4.3 16.0 All other 1.4 1.3 0.1 0.8 ------------ ------------ --------- ------ $ 461.6 $ 435.3 $ 26.3 6.0 ============ ============ ========= ======
Our domestic lottery service revenues were $254.9 million in the first six months of fiscal 2004, compared to $246.9 million in the first six months of fiscal 2003, up $8.0 million, or 3.2%, primarily due to higher service revenues from an increase in sales by our domestic lottery customers. 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. Our international lottery service revenues were $173.8 million in the first six months of fiscal 2004, compared to $159.9 million in the first six months of fiscal 2003, up $13.9 million, or 8.7%. This 8.7% increase includes higher service revenues of approximately 11% from an increase in sales by our international lottery customers and the effect of higher jackpot activity (primarily in Brazil) of approximately 2%, partially offset by the combined impact of net contract losses and contractual rate changes of approximately 4%. 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 and the successful introduction of new games. Service revenues from commercial transaction processing services were $31.5 million in the first six months of fiscal 2004, compared to $27.2 million in the first six months of fiscal 2003, up $4.3 million, or 16.0%. The acquisition of PolCard accounted for approximately 28% of this increase, which was partially offset by the overall weakening of the Brazilian real against the U.S. dollar on a year to date basis of approximately 10%. Product sales were $55.3 million in the first six months of fiscal 2004, compared to $17.0 million in the first six months of fiscal 2003, up $38.2 million. This increase was primarily driven by the sale of our new interactive, web-based software application, ES Interactive, to our customer in the United Kingdom. Our service margins improved from 37.1% in the first six months of fiscal 2003 to 43.8% in the first six months of fiscal 2004. This 6.7 percentage point increase was primarily due to lower depreciation of 3.4 percentage points (principally related to fully depreciated assets associated with our contract with Caixa Economica Federal in Brazil), 1.6 percentage points from the absence of certain consulting costs incurred during the first six months of the prior year, and the balance of the increase due to the combined impact of higher services revenues and our ongoing efforts to improve cost efficiencies. -36- Our product margins fluctuate depending on the mix, volume and timing of product sales contracts. Our product margins were to 32.3% in the first six months of fiscal 2004 compared to 39.2% in the first six months of fiscal 2003. Fiscal 2004 product margins are returning to historical levels when compared to the higher margin product sales which we recorded in the first half of fiscal 2003, primarily reflecting a high volume of higher margin equipment sales. Operating expenses were $79.8 million in the first six months of fiscal 2004, compared to $59.5 million in the first six months of fiscal 2003, up $20.3 million, or 34.2%. This increase was driven by $14.8 million of increased spending on research and development as we continue our efforts to accelerate the development and deployment of industry-leading products into the marketplace and to execute against our commercial services strategy. In addition, selling, general and administrative expense was up $5.5 million, primarily driven by business development activities in Poland and Mexico, increased marketing expenses primarily associated with trade shows and conferences, and the acquisition of PolCard. As a percentage of revenues, operating expenses were 15.4% and 13.1% during the first six months of fiscal 2004 and 2003, respectively. Weighted average diluted shares in the first six months of fiscal 2004 increased by 4.2 million shares to 63.0 million shares, primarily due to the convertibility during the first six months of this fiscal year of our $175 million principal amount of 1.75% Convertible Debentures into shares of our common stock, resulting in a decrease to diluted earnings per share of approximately $0.09. 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 80 out of 127 trading days in the first six months of fiscal 2004, and approximately 4 million shares were included in the computation of diluted earnings per share. Our effective income tax rate decreased from 38% in the first six months of fiscal 2003 to 37% in the second quarter of fiscal 2004 principally due to a larger percentage of international profits taxed at rates that are lower than the U.S. statutory tax rate and the increased recognition of research and development tax credits. Changes in Financial Position, Liquidity and Capital Resources During the first six months of fiscal 2004, we generated $170.5 million of cash from operations, which, along with cash on hand, was principally used to purchase $143.8 million of systems, equipment and other assets relating to contracts and to fund acquisitions of $41.0 million. At August 23, 2003, we had $94.3 million of cash and cash equivalents on hand, of which approximately $36 million was invested at a major U.S. financial institution and approximately $30 million was invested in tax-exempt money market funds. At the end of the fiscal 2004 second quarter, there was $290.3 million available for borrowing under our $300 million credit facility after considering $9.7 million of letters of credit issued and outstanding under the credit facility. Inventories decreased by $14.9 million, from $72.3 million at February 22, 2003 to $57.4 million at August 23, 2003, primarily due to the sale of ES Interactive to our customer in the United Kingdom, partially offset by a build up of inventory associated with product sales expected to be recorded during fiscal 2005. Other current assets increased by $10.1 million, from $18.7 million at February 22, 2003 to $28.8 million at August 23, 2003, primarily due to $5.8 million of prepayments and $3.3 million of value-added tax receivables, both related to ongoing lottery system installations, primarily in Europe. -37- Systems, equipment and other assets relating to contracts, net, increased by $93.4 million, from $410.9 million at February 22, 2003 to $504.3 million at August 23, 2003, primarily due to the purchase of $143.8 million of systems, equipment and other assets relating to contracts (principally related to lottery system implementations in California and Georgia), partially offset by depreciation expense. Goodwill, net, increased by $31.5 million, from $115.5 million at February 22, 2003 to $147.0 million at August 23, 2003, due to the acquisition of PolCard, the largest debit and credit card merchant transaction acquirer and processor in Poland, along with the acquisition of the remaining 20% of the equity of Europrint. Other assets increased by $18.7 million, from $79.2 million at February 22, 2003 to $97.9 million at August 23, 2003, primarily due to a $12.5 million up-front license fee we paid to the Rhode Island Lottery and $5.2 million of intangible assets recorded as a result of our acquisition of PolCard. Accounts payable decreased by $10.6 million, from $74.0 million at February 22, 2003 to $63.4 million at August 23, 2003, primarily due to the timing of payments related to ongoing lottery system installations. Employee compensation decreased by $9.2 million, from $37.5 million at February 22, 2003 to $28.3 million at August 23, 2003, primarily due to the payment, in the first quarter of fiscal 2004, of fiscal 2003 management incentive compensation and employee profit sharing. Advance payments from customers increased by $10.1 million, from $52.4 million at February 22, 2003 to $62.5 million at August 23, 2003, primarily due to advances received from customers related to product sales that are expected to be recorded during the second half of fiscal 2004 and during fiscal 2005, partially offset by the sale of ES Interactive to our customer in the United Kingdom. Taxes other than income taxes increased by $9.3 million, from $16.0 million at February 22, 2003 to $25.3 million at August 23, 2003, primarily due to $3.8 million of value-added tax payables related to ongoing lottery system installations and $4.1 million due to the acquisition of PolCard. Our business is capital-intensive. We currently estimate that net cash to be used for investing activities in fiscal 2004 will be in the range of $370 million to $380 million, including investments we made in September 2003 to acquire Interlott. We currently estimate that net cash to be used for investing activities in fiscal 2004 for the purchase of Interlott (which was consummated in September 2003) and investing activities subsequent to acquisition, will be in the range of $45 million to $50 million, of which $33.9 million is the cash portion of the purchase price for the acquisition. In addition, to complete the acquisition of Interlott, we issued common shares held in treasury having a market value of approximately $30 million and we also assumed approximately $22.5 million of Interlott debt. We expect our principal sources of liquidity to be existing cash balances, along with cash we generate from operations and borrowings under our credit facility. Our credit facility provides for an unsecured revolving line of credit of $300 million and matures in June 2006. As of August 23, 2003, 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 August 23, 2003, there was $290.3 million available for borrowing under the Credit Facility, after considering $9.7 million of letters of credit issued and outstanding. We currently expect that our cash flow from operations, existing cash balances and available borrowings under our credit facility 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 the cash portion of the Interlott acquisition, 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. Notwithstanding the foregoing, we may seek alternative -38- 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 $370 million to $380 million range of fiscal 2004 investing activities disclosed above. Details of our contractual obligations for long-term debt and operating leases as of February 22, 2003 are as follows (in millions):
Fiscal ---------------------------------------------------------------------------- 2004 2005 2006 2007 2008 Thereafter Total -------- -------- -------- -------- -------- ---------- -------- Long-term debt $ 7.0 $ 5.6 $ 5.1 $ 5.8 $ 95.6 $ 175.0 $ 294.1 Operating leases 18.7 14.8 7.3 33.4 3.1 6.1 83.4 -------- -------- -------- -------- -------- ---------- -------- Total $ 25.7 $ 20.4 $ 12.4 $ 39.2 $ 98.7 $ 181.1 $ 377.5 ======== ======== ======== ======== ======== ========== ========
Operating lease payments include a $28 million residual value payment that we may be required to pay in fiscal 2007, or earlier under certain limited circumstances, related to the lease of our world headquarters facilities. Off-Balance Sheet Arrangements We have a 50% limited partnership interest in West Greenwich Technology Associates, L.P. (the "Partnership"), which owns our world headquarters facilities and leases them to us. The general partner of the Partnership is an unrelated third party. We currently account for the Partnership using the equity method of accounting. The following is a summary of certain unaudited financial information of the Partnership, at and for the period ended August 23, 2003, used as the basis for applying the equity method of accounting (in millions):
August 23, 2003 (Unaudited) --------------- ---------- Earnings data: Net loss $ (0.4) Balance sheet data: Assets $ 17.7 Liabilities 27.8 Partners' deficit (10.1)
Beginning in the third quarter of fiscal 2004, which began on August 24, 2003, we will consolidate the Partnership in accordance with Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires the consolidation of a variable interest entity (as defined) by its primary beneficiary. As a result, we will record our world headquarters facilities owned by the Partnership as an asset, and the Partnership's debt obligation as a liability in our consolidated financial statements. We expect the adoption of this interpretation to increase balance sheet assets and liabilities in the range of $27 million to $30 million and to result in a one-time, non-cash, pre-tax gain in the range of $4 million to $5 million, or $0.05 per diluted share, that will be recorded in Other Income in our consolidated financial statements. The pre-tax gain will be recorded in Other Income and not as a cumulative-effect adjustment because the gain is not material to our consolidated financial statements. -39- 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 August 23, 2003:
Total potential commitments --------------- (in millions) Performance bonds $ 176.7 Financial guarantees 7.5 All other bonds 8.3 --------------- $ 192.5 ===============
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 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, at August 23, 2003, we guaranteed $5.2 million principal amount of loans made by an unrelated commercial lender to LTSC. The loans have a maturity date of January 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. 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 principally included in Other Liabilities in our Consolidated Balance Sheets at August 23, 2003 and February 22, 2003. 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 August 23, 2003, deferred product gross profit and deferred service revenue totaled $4.1 million and $6.7 million, respectively. 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 August 23, 2003, was $2.4 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. -40- 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. GAMING ENTERTAINMENT (DELAWARE) L.L.C. We have a 50% interest in Gaming Entertainment (Delaware) L.L.C. ("GED"). GED is a joint venture between us and a subsidiary of Full House Resorts, Inc. ("FHRI"). Pursuant to a 1995 management agreement ("Agreement"), GED manages a casino for Harrington Raceway, Inc. ("Harrington") and in return receives a percentage of gross revenues and operating profits as defined in the Agreement. Along with FHRI, we guarantee the payment of all amounts due Harrington under the Agreement. Our guarantee expires on February 1, 2012 or upon expiration of the Delaware Horse Racing Redevelopment Act. The consideration we receive in exchange for the guarantee are the equity earnings from our joint venture with FHRI. Market Risk Disclosures 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 rates. Our exposure to commodity price changes is not considered material and is managed through our procurement and sales practices. We did not own any marketable equity securities during the first six months of fiscal 2004. Interest rates 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. At August 23, 2003, the estimated fair value of our $95 million of fixed rate Senior Notes approximated $105.2 million (as determined by an independent investment banker). At August 23, 2003, a hypothetical 10% increase in interest rates would reduce the estimated fair value of the fixed rate Senior Notes to $104.2 million and a hypothetical 10% decrease in interest rates would increase the estimated fair value of the fixed rate Senior Notes to $106.2 million. At August 23, 2003, the estimated fair value of our $175 million principal amount of 1.75% Convertible Debentures was $268.6 million (based on a quoted market price of $153.50 per Debenture). At August 23, 2003, a hypothetical 10% increase in interest rates would reduce the estimated fair value of the Convertible Debentures to $267.7 million and a hypothetical 10% decrease in interest rates would increase the estimated fair value of the Convertible Debentures to $269.6 million. 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. During the first six months of fiscal 2004, we did not have any interest rate swap agreements in place. -41- Equity price risk At August 23, 2003, the estimated fair value of our $175 million principal amount of 1.75% Convertible Debentures was $268.6 million (based on a quoted market price of $153.50 per Debenture). At August 23, 2003, a hypothetical 10% increase in the market price of our common stock would increase the estimated fair value of the Convertible Debentures to $291.7 million and a hypothetical 10% decrease in the market price of our common stock would reduce the estimated fair value of the Convertible Debentures to $246.7 million. Foreign Currency Exchange Rates We are subject to foreign exchange exposures arising from current and anticipated transactions denominated in currencies other than our functional currency (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 current transactions and anticipated transactions denominated in foreign currencies. However, we do not engage in foreign currency speculation. At August 23, 2003, a hypothetical 10% adverse change in foreign exchange rates would result in a translation loss of $15.4 million that would be recorded in the equity section of our balance sheet. At August 23, 2003, a hypothetical 10% adverse change in foreign exchange rates would result in a net pre-tax transaction loss of $1.6 million that would be recorded in current earnings after considering the effects of foreign exchange contracts currently in place. At August 23, 2003, 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 2004 of $4.3 million, after considering the effects of foreign exchange contracts currently in place. The percentage of fiscal 2004 anticipatory cash flows that were hedged varied throughout the first six months of fiscal 2004, but averaged 51%. As of August 23, 2003, we had contracts for the sale of foreign currency of approximately $96.8 million (primarily Euro, pounds sterling and Czech koruna) and the purchase of foreign currency of approximately $73.6 million (primarily Euro, pounds sterling, Singapore dollars and Brazilian real). -42- Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See "Market Risk Disclosures" 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-15(e) under the Securities Exchange Act of 1934), and of any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during the quarterly period covered by this report. 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, and that no change in our internal control over financial reporting occurred during the quarterly period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Subsequent to the date of this evaluation, there have been 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. -43- PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS For information respecting certain legal proceedings, refer to Part I, Item 3 - "Legal Proceedings" and Note 11 to the Consolidated Financial Statements in our fiscal 2003 Annual Report on Form 10-K, as amended, and Part II, Item 1 - "Legal Proceedings" in our Quarterly Report for the quarterly period ended May 24, 2003. -44- Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) and (c) The Company's Annual Meeting of Shareholders was held on August 4, 2003 and in connection therewith, proxies were solicited by management pursuant to Regulation 14A under the Securities Exchange Act of 1934. An aggregate of 57,845,928 shares of the Company's common stock ("Shares") were issued and eligible to vote at the meeting. At the meeting, the following matters (not including ordinary procedural matters) were submitted to a vote of the holders of Shares, with the results indicated below: 1. Election of three directors to serve until the 2006 Annual Meeting The following incumbent directors were reelected. The tabulation of votes was as follows:
Nominee For Withheld - ----------------- ----------------- ---------------- Burnett W. Donoho 49,996,946 Shares 2,440,707 Shares James F. McCann 51,840,268 Shares 597,385 Shares W. Bruce Turner 43,543,121 Shares 8,894,532 Shares
2. Approval of the Company's Corporate Financials Management Incentive Plan The tabulation of votes was as follows:
Abstentions For Against (including broker non-votes) - ----------------- ---------------- ---------------------------- 44,590,155 Shares 2,774,230 Shares 5,073,268 Shares
3. Ratification of Ernst & Young LLP, Independent Certified Public Accountants, as auditors for the fiscal year ending February 28, 2004 The tabulation of votes was as follows:
For Against Abstentions - ----------------- ---------------- ------------ 48,779,770 Shares 3,649,253 Shares 8,630 Shares
-45- 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 reports 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 June 18, 2003 describing an administrative legal proceeding in its initial stages that was commenced against us in Brazil. (ii) We filed a report on Form 8-K on June 19, 2003 incorporating by reference a press release we issued on June 19, 2003 announcing our fiscal 2004 first quarter results. In addition, we incorporated by reference the transcripts from our fiscal 2004 first quarter earnings conference call held on June 19, 2003. (iii) We filed a report on Form 8-K on August 11, 2003 incorporating by reference a press release we issued on August 7, 2003 describing that we launched an offer to purchase existing indebtedness. -46- 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: October 1, 2003 By /s/ Jaymin B. Patel ----------------------------------------------------- Jaymin B. Patel, Senior Vice President and Chief Financial Officer (Principal Financial Officer) Date: October 1, 2003 By /s/ Robert J. Plourde ----------------------------------------------------- Robert J. Plourde, Vice President and Corporate Controller (Principal Accounting Officer) -47- EX-12.1 3 y90247exv12w1.txt COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES . . . EXHIBIT 12.1 GTECH HOLDINGS CORPORATION AND SUBSIDIARIES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES
(Unaudited) Six Months Ended ------------------------------------- August 23, August 24, 2003 2002 ------------ -------------- (Dollars in thousands, except ratios) Earnings: Income before income taxes $ 142,067 $ 108,466 Add: Interest on indebtedness 4,011 5,643 Equity income, net of distributions (289) 653 Minority losses 1,578 1,141 Portion of rents representative of the interest factor 3,222 3,222 Amortization of capitalized interest 384 624 ---------- ----------- Adjusted earnings $ 150,973 $ 119,749 ========== =========== Fixed charges: Interest on indebtedness 4,011 5,643 Portion of rents representative of the interest factor 3,222 3,222 Capitalized interest 1,080 - ---------- ----------- Total fixed charges $ 8,313 $ 8,865 ========== =========== Ratio of earnings to fixed charges 18.16 13.51 ========== ===========
EX-31.1 4 y90247exv31w1.txt SECTION 302 CERTIFICATION Exhibit 31.1 CERTIFICATION I, W. Bruce Turner, President and Chief Executive Officer of GTECH Holdings Corporation (the "Company"), certify that: (1) I have reviewed this quarterly report on Form 10-Q of the Company; (2) Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; (3) Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this quarterly report; (4) The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d-15(e)) for the Company and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report was being prepared; (b) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and (c) disclosed on this quarterly report any change in the Company's internal control over financial reporting (as defined in Exchange Act Rules 13-15(f) and 15d-15(f)) that occurred during the Company's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and (5) The Company's other certifying officer and I have disclosed, based on our most recent evaluation, of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors: (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. GTECH HOLDINGS CORPORATION Date: October 1, 2003 By /s/ W. Bruce Turner -------------------------------------- W. Bruce Turner President and Chief Executive Officer EX-31.2 5 y90247exv31w2.txt SECTION 302 CERTIFICATION Exhibit 31.2 CERTIFICATION I, Jaymin B. Patel, Senior Vice President and Chief Financial Officer of GTECH Holdings Corporation (the "Company"), certify that: (1) I have reviewed this quarterly report on Form 10-Q of the Company; (2) Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; (3) Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this quarterly report; (4) The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d-15(e)) for the Company and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report was being prepared; (b) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and (c) disclosed on this quarterly report any change in the Company's internal control over financial reporting (as defined in Exchange Act Rules 13-15(f) and 15d-15(f)) that occurred during the Company's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and (5) The Company's other certifying officer and I have disclosed, based on our most recent evaluation, of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors: (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. GTECH HOLDINGS CORPORATION Date: October 1, 2003 By /s/ Jaymin B. Patel -------------------------------------- Jaymin B. Patel, Senior Vice President and Chief Financial Officer EX-32.1 6 y90247exv32w1.txt SECTION 906 CERTIFICATION Exhibit 32.1 GTECH HOLDINGS CORPORATION CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of GTECH Holdings Corporation (the "Company") on Form 10-Q for the period ending August 23, 2003 as filed with the Securities and Exchange Commission on the Date hereof (the "Report"), I, W. Bruce Turner, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C section 1350, as adopted pursuant to sections 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. GTECH HOLDINGS CORPORATION Date: October 1, 2003 By /s/ W. Bruce Turner ----------------------------------------------- W. Bruce Turner President and Chief Executive Officer EX-32.2 7 y90247exv32w2.txt SECTION 906 CERTIFICATION Exhibit 32.2 GTECH HOLDINGS CORPORATION CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of GTECH Holdings Corporation (the "Company") on Form 10-Q for the period ending August 23, 2003 as filed with the Securities and Exchange Commission on the Date hereof (the "Report"), I, Jaymin B. Patel, Senior Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C section 1350, as adopted pursuant to sections 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. GTECH HOLDINGS CORPORATION Date: October 1, 2003 By /s/ Jaymin B. Patel ------------------------------------------------ Jaymin B. Patel, Senior Vice President and Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----