Higher Costs Spoil IGT's 3Q

International Game Technology ( IGT - Analyst Report ) reported dismal third quarter 2012 results, with earnings of 23 cents per share missing the Zacks Consensus Estimate by a nickel. Earnings plunged 65.7% year over year hurt by higher operating expenses in the quarter.

Quarter Details

Total revenue increased 9.0% year over year to $532.8 million in the quarter, primarily driven by higher North America product sales and interactive businesses. However, reported revenue fell well short of the Zacks Consensus Estimate of $560.0 million.

Gaming Operations revenue jumped 12.6% year over year to $301.2 million in the quarter, primarily due to strong performance of the interactive business and higher installed base. Average revenue per unit (ARPU) increased 5.4% year over year to $58.55. At the end of the quarter, the company’s Gaming Operations installed base totaled 56,900 units, up 3,600 units from the year-ago quarter.

Product Sales climbed 4.5% year over year to $2 million, primarily due to higher domestic replacement sales (up 53.1% year over year). IGT shipped 11,600 machines during the quarter compared with 8,900 units in the year-ago quarter. ARPU in the reported quarter was $20,000 versus $24,900 in the prior-year quarter. Average machine sales price was $13,700 versus $15,400 in the year-ago quarter.

Revenues from North America stood at $416.0 million, up 14.3% year over year, while international operations revenue decreased 6.6% year over year to $116.8 million in the reported quarter.

Gross profit increased 5.0% year over year to $302.6 million. However, gross margin decreased 220 basis points (bps) to 56.8% in the third quarter. Gaming gross margin decreased 240 bps year over year to 59.2%, while Product sales gross margin contracted 230 bps on a year-over-year basis to 53.7% in the quarter.

Operating expenses were $175.0 million, up 18.4% year over year and as a percentage of revenue, operating expenses jumped 260 bps annually in the reported quarter.

Operating income declined 8.2% year over year to $129.3 million, primarily attributed to higher operating expenses. Operating margin decreased 450 bps to 24.3% in the quarter. Net income decreased 10.7% year over year to $68.5 million in the reported quarter.

As of June 30, 2012, cash and investments (including restricted cash) were $327.5 million versus $360.6 million, as of March 31, 2011. Long-term debt stood at $1.97 billion, up from $1.66 in the previous quarter, reflecting increased borrowings under the company’s revolving credit facility.

During the quarter, IGT repurchased 2.0 million shares for an average price of $14.48 per share, totaling $25.0 million. IGT announced a new $1.0 billion share repurchase authorization and entered into a $400 million accelerated stock buyback (ASB) agreement to repurchase its common stock.

Guidance

IGT did not provide any specific earnings guidance for the fourth quarter. The company expects Gaming operations gross margin to be approximately 62.0% for the fourth quarter. Product sales gross margin is expected to be 52.0% for the fourth quarter of 2012.

For fiscal 2012, IGT reiterated its earnings outlook, which is expected to remain in the range of 98 cents to $1.04 per share.

Our Take

We believe that increasing investment in product development will drive operating costs going forward. This will remain an overhang on the stock in the near term. Moreover, fewer new openings and increased competition from Bally Technologies Inc. ( BYI - Snapshot Report ) and WMS Industries Inc. ( WMS - Snapshot Report ) will keep the stock range bound in the near term.

However, improving domestic gaming environment, international expansion opportunities, an impressive product portfolio, cost-cutting initiatives, lesser dependence on the domestic machine replacement cycle, new contract wins, and strong growth from the interactive business will drive growth going forward.

We have a Neutral recommendation on the stock over the long term (6-12 months). Currently, IGT carries a Zacks #2 Rank, which implies a Buy rating in the short term.