10-K 1 y08085e10vk.txt GTECH HOLDINGS CORPORATION UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ==================== FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED: FEBRUARY 26, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ___________________ TO ___________________. COMMISSION FILE NUMBER 1-11250 ===================== GTECH HOLDINGS CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 05-0450121 (State or other jurisdiction (I.R.S. Employer Identification Number) of incorporation or organization) 55 TECHNOLOGY WAY, WEST GREENWICH, RHODE ISLAND 02817 (Address of Principal Executive Offices) Registrant's telephone number, including area code: (401) 392-1000 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class: Name of Each Exchange on which Registered: -------------------- ----------------------------------------- Common Stock $.01 par value New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None ---- ======================= 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 twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2. YES [X] NO [ ] The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of August 28, 2004 was approximately $2.6 billion. On April 15, 2005, there were 114,911,459 outstanding shares of the registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE
Document Location in Form 10-K -------- --------------------- Portions of Registrant's Proxy Statement For its 2005 Annual Meeting of Shareholders Part III
================================================================================ ========= GTECH HOLDINGS CORPORATION FORM 10-K FOR THE FISCAL YEAR ENDED FEBRUARY 26, 2005 INDEX
Page ---- PART I Item 1. Business 4 Item 2. Properties 40 Item 3. Legal Proceedings 41 Item 4. Submission of Matters to a Vote of Security Holders 48 Additional Information - Executive Officers 48 PART II Item 5. Market For Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 51 Item 6. Selected Financial Data 53 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 54 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 83
Page ---- Item 8. Financial Statements and Supplementary Data 84 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 150 Item 9A. Controls and Procedures 151 Item 9B. Other Information 153 PART III Item 10. Directors and Executive Officers of the Registrant 154 Item 11. Executive Compensation 154 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 154 Item 13. Certain Relationships and Related Transactions 154 Item 14. Principal Accountant Fees and Services 154 PART IV Item 15. Exhibits and Financial Statement Schedules 155
PART I When used in this report, the terms "Company", "we", "our" and "us" refer to GTECH Holdings Corporation ("Holdings") and its consolidated subsidiaries, including GTECH Corporation ("GTECH"). ITEM 1. BUSINESS GENERAL We are a leading provider of gaming and technology solutions worldwide with over $1.25 billion in revenues and more than 5,300 employees on six continents. We leverage our global lottery experience and capabilities to offer a full range of game content and solutions and financial transaction processing services. We are the world's leading operator of highly-secure online lottery transaction processing systems, doing business in 53 countries worldwide, and we have a growing presence in commercial gaming technology and financial services transaction processing. Our core market is the lottery industry, for which we design, sell and operate a complete suite of lottery-enabled point-of-sale terminals that are electronically linked with a centralized transaction processing system which mediates lottery funds between the retailer, where a transaction is enabled, and the lottery authority. We currently operate, provide equipment and services to, or have entered into contracts to operate or provide equipment and services in the future to, 26 of the 41 online lottery authorities in the United States, and 65 of the 121 international online lottery authorities. We provide integrated online lottery transaction processing solutions, services and products to governmental lottery authorities and governmental licensees worldwide. We offer our customers a full range of lottery technology services, including the design, assembly, installation, operation, maintenance and marketing of online lottery systems and instant-ticket support systems. Our lottery systems consist of numerous lottery terminals located in retail outlets, central computer systems, systems software and game software, and communications equipment which connects the terminals and the central computer systems. Historically, the majority of our lottery customers in the United States have entered into long-term service contracts (typically at least five to seven years in duration) pursuant to which we provide, operate and maintain the customers' online lottery systems in return for a transaction processing fee typically expressed as an agreed percentage of the gross lottery sales. Many of our international lottery customers have purchased their online lottery systems, although some, especially lottery authorities in Eastern Europe, Latin America and Asia, have entered into long-term service contracts with us. In recent years, lottery authorities have recognized that by offering new games or products, they often are able to generate significant additional revenues. An important part of our strategy is to develop new products and services for our customers in order to increase their lottery revenues. For example, during fiscal 2005, we expanded our lottery game offerings by entering into licensing agreements with Hasbro Properties, Inc. (granting us rights to develop and distribute select lottery products featuring Hasbro Inc.'s Monopoly(R) and Battleship(R) brands), and New Vision Gaming (granting us exclusive rights to offer the flagship games Players Choice(R) and Worldwide Poker(R)). During fiscal 2005, we also developed and introduced HotTrax,(R) an exciting new lottery monitor game that creates the illusion of an auto race that is taking place in three dimensions; received an award, following a competitive procurement, from the Multi-State Lottery Association to support the development of the first ever system that permits the sale of video lottery products across jurisdictions and over equipment supplied by numerous vendors; and announced the development of GamePoint,(TM), our lottery vending machine that permits the sale both of online and instant tickets. Other indicative online products and services introduced in recent years to increase lottery revenues for our customers include Aladdin(TM), the Doubletake(TM) game, e-scratch(TM) and our family of self-service terminals, including Instant Ticket Vending Machines (also known as Lottery Product Vending Machines or Instant Ticket Dispensing Machines; "ITVMs") designed, manufactured and marketed by Interlott Technologies, Inc. ("Interlott"), which we acquired during fiscal 2004, and, our Altura(R) family of terminals, the Altura Self-Service Terminal or Altura SST(TM). Aladdin is a credit-card sized lottery ticket, that, through the use of magnetic strip and thermal printing technology, can be reused up to 500 times, and which also can be employed in various non-lottery commercial contexts. The Doubletake game is an online lottery game that permits players to purchase an additional game with instant-ticket features, thus enhancing wagering interest. Our e-scratch product is a web-based interactive suite of scratch and reveal games that combines the security and convenience of online play with the entertainment, branded content and immediate gratification of instant-tickets. Interlott's EDS-Q family of ITVMs offers flexibility and expandability (from a four to 24 game capacity) as well as the industry's first transaction processing connectivity to in-store lottery terminals and lottery authority central systems. Our Altura SST combines the functionality of ITVMs with the capability of selling online lottery products through a touch screen interface. In recent years, we have also introduced various instant-ticket support services, products and systems to assist our lottery customers in increasing revenue. In appropriate circumstances, we have extended our online and video lottery product offerings through acquisitions. During fiscal 2005, we completed the acquisition of Spielo Manufacturing, Inc. ("Spielo"), a leading provider of video lottery terminals and related products and services to the global gaming industry. See "Significant Developments Since The Start of Fiscal 2005", and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", below. In recent years, we have taken steps to broaden our offerings of transaction processing services outside of our core market of providing online lottery services into the gaming technology and financial services markets. During fiscal 2005, we entered into an agreement with the owners of the privately-held Gauselmann Group ("Gauselmann") to acquire a 50 percent controlling equity interest in the Atronic group of companies ("Atronic") owned by Gauselmann. Atronic, the leading video slot provider in Europe, Russia and Latin America, has a growing presence in the United States and is licensed in 196 worldwide gaming jurisdictions. Subject to obtaining required regulatory and gaming license approvals and the satisfaction of other closing conditions, we expect that the closing of this acquisition will take place in December 2006. In addition, during fiscal 2005, our majority-owned commercial services subsidiary, PolCard S.A., completed the acquisition of BillBird S.A., the leading provider of electronic bill payment services in Poland. See "Significant Developments Since The Start of Fiscal 2005", and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", below. GTECH Corporation was founded in 1980. GTECH Holdings Corporation acquired GTECH Corporation in a leveraged buy-out in February 1990. Our World Headquarters is located at 55 Technology Way, West Greenwich, Rhode Island 02817, and our telephone number is (401) 392-1000. Our Internet address is www.gtech.com. We make available free of charge through our Internet address our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. In addition, we review our financial results and business prospects on quarterly earnings conference calls, and from time-to-time on other conference call presentations, to which we invite the public to listen. We typically announce by press release the date and time of, and dial-in and Internet-access information respecting, such conference calls several days in advance, and make materials respecting matters discussed on such conference calls available free of charge through our Internet address. FORWARD-LOOKING INFORMATION Certain statements contained or incorporated by reference in this report are forward-looking statements within the meaning of the United States Private Litigation Reform Act of 1995. We identify forward-looking statements by words such as "may", "will", "should", "could", "expect", "plan", "anticipate", "intend", "believe", "estimate", "continue", "project" or similar terms that refer to the future. Such statements include, without limitation, statements relating to: - the future prospects for and stability of the lottery industry and other businesses in which we are engaged or expect to be engaged; - our future operating and financial performance (including, without limitation, expected future growth in revenues, profit margins and earnings per share); - our ability to secure and protect trademarks and other intellectual property rights; - our ability to retain existing contracts and to obtain and retain new contracts; - competition in the online lottery industry and other businesses in which we are engaged or may engage and the impact of competition on our revenues and profitability; - our ability to realize the anticipated benefits of our acquisitions; 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, among other things, the matters described in this report under "Certain Factors That May Affect Future Performance" below. CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE The future performance of our business is subject to the factors set forth below, as well as the other considerations described elsewhere herein. GOVERNMENT REGULATIONS AND OTHER ACTIONS AFFECTING THE ONLINE LOTTERY INDUSTRY COULD HAVE A NEGATIVE EFFECT ON OUR BUSINESS AND SALES. In the United States and in many international jurisdictions where we currently operate or seek to do business, online lotteries are not permitted unless expressly authorized by law. The successful implementation of our growth strategy and our business could be materially adversely affected if jurisdictions that do not currently authorize lotteries do not approve online lotteries or if those jurisdictions that currently authorize lotteries do not continue to permit such activities. Once authorized, the ongoing operations of lotteries and lottery operators are typically subject to extensive and evolving regulation. Lottery authorities generally conduct an intensive investigation of the winning vendor and its employees prior to and after the award of a lottery contract. Lottery authorities with which we do business may require the removal of any of our employees deemed to be unsuitable and are generally empowered to disqualify us from receiving a lottery contract or operating a lottery system as a result of any such investigation. Some jurisdictions also require extensive personal and financial disclosure and background checks from persons and entities beneficially owning a specified percentage (typically five percent or more) of our securities. The failure of these beneficial owners to submit to such background checks and provide required disclosure could jeopardize the award of a lottery contract to us or provide grounds for termination of an existing lottery contract. Additional restrictions are often imposed by international jurisdictions in which we market our lottery systems upon foreign corporations, such as us, seeking to do business there. Further, 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 Item 3, "Legal Proceedings - Brazilian Legal Proceedings - The CEF Contract Proceedings," and Item 8, Note 14 to Notes to Consolidated Financial Statements, below, for a discussion of a civil action initiated by federal attorneys with Brazil's Public Ministry against GTECH Brasil Ltda., our Brazilian subsidiary, ("GTECH Brazil"), and two of our former employees, among others; a criminal action recommended by federal attorneys with Brazil's Public Ministry alleging employee misconduct against one of our current and one of our former employees, among others, and a related SEC investigation; and other legal proceedings involving our contractual relationship with Caixa Economica Federal, the Brazilian bank and operator of Brazil's National Lottery ("CEF"). Finally, sales generated by online lottery games are dependent upon decisions over which we have no control made by lottery authorities with respect to the operation of these games, such as matters relating to the marketing and prize payout features of online lottery games. Because we are typically compensated in whole or in part based on a jurisdiction's gross online lottery sales, lower than anticipated sales due to these factors could have a material adverse effect on our revenues. WE MAY BE SUBJECT TO ADVERSE DETERMINATIONS IN LEGAL PROCEEDINGS (INCLUDING PREVIOUSLY ANNOUNCED LEGAL PROCEEDINGS IN BRAZIL) WHICH COULD RESULT IN SUBSTANTIAL MONETARY JUDGMENTS OR REPUTATIONAL DAMAGE. We are presently involved in a civil action that was initiated by federal attorneys with Brazil's Public Ministry against our subsidiary, GTECH Brazil, and two of our former employees, among others; a criminal action recommended by federal attorneys with Brazil's Public Ministry alleging employee misconduct by one of our current and one of our former employees, among others, and a related SEC investigation; and other legal proceedings involving our contractual relationship with CEF. We refer you to Item 3, "Legal Proceedings - Brazilian Legal Proceedings - the CEF Contract Proceedings," below for a more detailed discussion of these matters. We are also subject to other legal proceedings which are described more fully in this report in Item 3 under "Legal Proceedings." We may not prevail in any of these legal proceedings. If we are not successful in defending these legal proceedings, we could incur substantial monetary judgments or penalties. If we are not successful in defending these proceedings, we may also suffer damage to our reputation, and whether or not we are successful, the proceedings may occupy the time and attention of our senior management. OUR LOTTERY OPERATIONS ARE DEPENDENT UPON OUR CONTINUED ABILITY TO RETAIN AND EXTEND OUR EXISTING CONTRACTS AND WIN NEW CONTRACTS. We derive the majority of our revenues and cash flow from our portfolio of long-term facilities management contracts. Upon the expiration of a contract, lottery authorities may award new contracts through a competitive procurement process. In addition, our lottery contracts typically permit a lottery authority to terminate the contract at any time for failure to perform and for other specified reasons, and many of our contracts permit the lottery authority to terminate the contract at will with limited notice and do not specify the compensation, if any, to which we would be entitled were such termination to occur. In addition, in the event that we are unable or unwilling to perform, some of our lottery contracts permit the lottery authority to acquire title to our system-related equipment and software during the term of the contract or upon the expiration or earlier termination of the contract, in some cases without paying us any compensation related to the transfer of that equipment and software to the lottery authority. The termination of or failure to renew or extend one or more lottery contracts, the renewal or extension of one or more lottery contracts on materially altered terms or the loss of our assets without compensation could, depending upon the circumstances, have a material adverse effect on our business, financial condition, results and prospects. SLOW GROWTH OR DECLINES IN SALES OF ONLINE LOTTERY GOODS AND SERVICES COULD LEAD TO LOWER REVENUES AND CASH FLOWS. In recent years, as the United States lottery industry has matured, the rate of lottery sales growth has moderated and certain of our customers have from time-to-time experienced a downward trend in sales. These developments may in part reflect increased competition that the lottery industry has experienced in recent years for the consumers' entertainment dollar, including by virtue of a proliferation of destination gaming venues, and an increased availability of Internet gaming opportunities, as well as the relative difficulty of attracting younger consumers to playing online lottery games. Our future success will depend, in part, on the success of the lottery industry, as a whole, in attracting and retaining players in the face of such increased competition for the consumers' entertainment dollar (which competition may well increase further in the future), as well as our own success in developing innovative products and systems to achieve this goal. Our future success also will depend, in part, on our ability to develop innovative products and services to permit us to successfully market transaction processing goods and services outside of the lottery industry. Our failure to achieve these goals could have a material adverse effect on our business, financial condition and results and prospects. WE DERIVE OVER HALF OF OUR REVENUES FROM FOREIGN JURISDICTIONS (INCLUDING OVER 7.4% IN FISCAL 2005 FROM BRAZILIAN OPERATIONS) AND ARE SUBJECT TO THE ECONOMIC, POLITICAL AND SOCIAL INSTABILITY RISKS OF DOING BUSINESS IN FOREIGN JURISDICTIONS. We are a global business and derive a substantial portion of our revenue from our operations outside the United States. In particular, in fiscal 2005, we derived approximately 52% of our revenues from our international operations and approximately 7.4% of our revenues from our Brazilian operations alone (including 7.2% of our revenues from the National Lottery of Brazil, our second largest customer in fiscal 2005 based on annual revenues). In addition, a substantial portion of our assets are held outside of the United States and could be prevented by a foreign jurisdiction from leaving that country. On June 25, 2004 the judge hearing the civil action initiated by the public ministry attorneys in the Federal Court of Brasilia against GTECH Brazil and two of our former employees, among others, granted a procedural injunction ordering that 30% of payments due to GTECH Brazil from CEF under its current contract be withheld and deposited into an account maintained by the court. The court also ordered that assets of GTECH Brazil, with certain exceptions, be identified to the court so as to prevent their transfer or disposition. We filed an appeal of this procedural injunction, and on March 22, 2005, a panel of judges of the Brazilian Federal Court of Appeals issued an order discontinuing the withholding of payments due to GTECH Brazil from CEF, removing the restrictions on the transfer or sale of our Brazilian assets, and requiring the return to us of amounts in excess of 40 million Brazilian reals that had been held in escrow pursuant to the procedural injunction, thereby permitting the return to us of approximately $11 million of the approximately $26 million held in escrow as of February 26, 2005. This order of the Brazilian Federal Court of Appeals may be appealed by the Brazilian Public Attorneys. See Item 3, "Legal Proceedings - Brazilian Legal Proceedings - The CEF Contract Proceedings" for a more detailed discussion of this matter. 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. Other economic risks that our international activity subjects us to might include inflation, foreign exchange risks (both depreciation and devaluation), illiquid foreign exchange markets, high interest rates, debt default, unstable capital markets and foreign direct investment restrictions. Political risks include change of leadership, change of governmental policies, new foreign exchange controls regulating the flow of money into or out of a country, failure of a government to honor existing contracts, changes in tax laws and corruption, as well as global risk aversion driven by political unrest, war and terrorism. Finally, social instability risks include high crime in the countries in which we operate due to poor economic and political conditions, riots, unemployment and poor health conditions. These factors may affect our work force as well as the general business environment in a country. See Item 8, Note 25 to Notes to Consolidated Financial Statements included in this report, for additional financial information respecting geographic areas where we conduct business. The occurrence of any of these events in the markets where we operate could jeopardize or limit our ability to transact business in those markets in the manner we expect and could have a material adverse effect on our business, financial condition, results and prospects. 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. Our consolidated financial results are significantly affected by foreign currency exchange rate fluctuations. Foreign currency exchange rate exposures arise from current transactions and anticipated transactions denominated in currencies other than United States dollars and from the translation of foreign currency balance sheet accounts into United States dollar balance sheet accounts. We are exposed to currency exchange rate fluctuations because a significant portion of our revenues is denominated in currencies other than the United States dollar. These exchange rate fluctuations have in the past adversely affected our operating results and may continue to adversely affect our results of operations and the value of our assets outside the United States. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," below. WE HAVE A CONCENTRATED CUSTOMER BASE AND THE LOSS OF ANY OF OUR LARGER CUSTOMERS (OR LOWER SALES FROM ANY OF THESE CUSTOMERS) COULD LEAD TO LOWER REVENUE. Revenue from our top ten customers accounted for approximately 46% of our total revenues in fiscal 2005. If we were to lose any of these larger customers, or if these larger customers experience slow lottery ticket sales and consequently reduced lottery revenue, our business, financial condition, results and prospects could suffer. Revenue under our contract with CEF attributable to the National Lottery of Brazil accounted for 7.2% of our revenues in fiscal 2005. We are currently involved in negotiations with CEF respecting the possible extension of the term of our contract beyond its May 2005 scheduled termination date, or the execution of a new contract with CEF for the provision of goods and services by us after this date. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY. We have experienced and may continue to experience significant fluctuations in our operating results from quarter to quarter due to such factors as 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. Fluctuations in our operating results from quarter to quarter may cause our operating results to be below the expectations of securities analysts and investors. WE OPERATE IN A HIGHLY COMPETITIVE ENVIRONMENT AND INCREASED COMPETITION MAY CAUSE US TO EXPERIENCE LOWER NET CASH FLOWS OR TO LOSE CONTRACTS. The online lottery industry has faced increased competition in recent years for the consumers' entertainment dollar, including from a proliferation of destination gaming venues, and an increased availability of Internet gaming opportunities. In addition, in recent years there has been increased competition among domestic and international participants in the online lottery industry, which could adversely affect our ability to win renewals of contracts from our existing customers or to win contract awards from other lottery authorities. In addition, awards of contracts to us are, from time to time, challenged by our competitors. Increased competition also may have a material adverse effect on the profitability of contracts which we do obtain. See "Competition" below. Over the past several fiscal years, we have experienced and may continue to experience a reduction in the percentage of lottery ticket sales that we receive from certain customers resulting from contract rebids, extensions and renewals due to a number of factors, including the substantial growth of lottery sales, reductions in the cost of technology and telecommunications services and general and competitive dynamics. We are unable to determine at this time the likely effect of this trend on our business. See Item 7, "Management's Discussion and Analysis of Financial Condition and Result of Operations" below. WE ARE SUBJECT TO SUBSTANTIAL PENALTIES FOR FAILURE TO PERFORM UNDER OUR CONTRACTS. Our lottery contracts typically permit termination of the contract at any time for failure by us to perform and for other specified reasons and generally contain demanding implementation and performance schedules. Failure to perform under these contracts may result in substantial monetary liquidated damages, as well as contract termination. These provisions in our lottery contracts present an ongoing potential for substantial expense. Lottery contracts also generally require us to post a performance bond, which in some cases may be substantial, to secure our performance under such contracts. We paid or incurred liquidated damages with respect to our contracts in an amount equal to 0.18%, 0.50%, 0.47%, 0.14%, and 0.47% of our annual revenues in fiscal 2005, 2004, 2003, 2002 and 2001, respectively. If we incur substantial liquidated damages in the future, it could significantly reduce the amount of funds that we have available for other uses in our business and may delay or prevent us from pursuing and achieving our growth strategy, which could have a material adverse effect on our business, financial condition, results and prospects. WE MAY NOT BE ABLE TO RESPOND TO TECHNOLOGICAL CHANGES OR TO SATISFY FUTURE TECHNOLOGY DEMANDS OF OUR CUSTOMERS IN WHICH CASE WE COULD FALL BEHIND OUR COMPETITORS. Most of our software and hardware products are based on proprietary technologies. While we believe that certain of our technologies, such as our Enterprise Series(TM) open-architecture software platform, provides an industry standard, if we were to fail to develop our product and service offerings to take advantage of technological developments, we may fall behind our competitors and our business, financial condition, results and prospects could suffer. IF WE ARE UNABLE TO MANAGE POTENTIAL RISKS RELATED TO ACQUISITIONS, OUR BUSINESS AND GROWTH PROSPECTS COULD SUFFER. Part of our growth strategy involves acquisitions designed to extend our product offerings and customer base. During fiscal 2004, we acquired Interlott Technologies, Inc., a leading provider of instant ticket vending machines for the worldwide lottery industry, and a controlling equity position in PolCard S.A., a leading debit and credit card merchant transaction acquirer and processor in Poland ("PolCard"). During fiscal 2005, we acquired Spielo Manufacturing Incorporated, a leading provider of video lottery terminals and related products and services to the global gaming industry, and Leeward Islands Lottery Holding Company, Inc. ("LILHCo"), a lottery holding company headquartered on the Caribbean islands of Antigua and St. Croix. In September 2004, PolCard acquired privately-held BillBird S.A., a leading provider of electronic bill payment services in Poland. Finally, in December 2004 we announced that we had signed an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") from the owners of the Gauselmann Group, in a transaction which we expect to close in December 2006. Atronic is a video slot manufacturer that is a market leader in Europe, Russia, and Latin America, with a presence in the United States. See "Significant Developments Since Start of Fiscal 2005" and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operation," below. Our ability to continue to expand successfully through acquisitions depends on many factors, including our ability to identify acquisition prospects and negotiate and close transactions. Even if we complete an acquisition, the integration of an acquired business into our operations involves numerous risks, including difficulties in integrating an acquired company's hardware and software products and services with our own; the diversion of our resources and management's attention from other business concerns; the potential loss of key employees; risks associated with entering markets in which we may have little experience; and the day-to-day management of a substantially larger and more geographically diverse combined company. We may not realize the synergies, operating efficiencies, market position or revenue growth we anticipate from acquisitions and our failure to effectively manage the above risks and other problems associated with acquisitions could have a material adverse effect on our business, growth prospects and financial performance. Acquisitions outside of our core lottery market may subject us to enhanced competition. For example, with the completion of our acquisition of Spielo and our announced acquisition of a 50% controlling equity interest in Atronic, we have entered the broader gaming technology and services industry, where we expect to encounter significant competition. Acquisitions also pose the risk that we may be exposed to successor liability relating to actions by an acquired company and its management before the acquisition. The due diligence we conduct in connection with an acquisition, and any contractual indemnities we may receive from sellers of acquired companies, may not be sufficient to protect us from, or compensate us for, actual liabilities. A material liability associated with an acquisition could also adversely affect our financial position and reduce the anticipated benefits of the acquisition. EXPANSION OF THE GAMING INDUSTRY FACES OPPOSITION WHICH COULD LIMIT OUR ACCESS TO SOME MARKETS. Gaming opponents continue to persist in efforts to curtail the expansion of legalized gaming. We can give no assurance that this opposition will not be successful in preventing the legalization of online gaming in jurisdictions where these activities are presently prohibited or prohibiting or limiting the expansion of online gaming where it is currently permitted, in either case to the detriment of our business, financial condition, results and prospects. OUR BUSINESS PROSPECTS AND FUTURE SUCCESS DEPEND UPON OUR ABILITY TO ATTRACT AND RETAIN QUALIFIED EMPLOYEES. Our business prospects and future success depend, in part, upon our ability to attract and to retain qualified managerial, marketing and technical employees. Competition for such employees is sometimes intense, and we may not succeed in hiring and retaining the executives and other employees that we need. Our loss of or inability to hire key employees could have a material adverse effect on our business, financial condition, results and prospects. OUR BUSINESS PROSPECTS AND FUTURE SUCCESS RELY HEAVILY UPON THE INTEGRITY OF OUR EMPLOYEES AND EXECUTIVES AND THE SECURITY OF OUR SYSTEMS. The real and perceived integrity and security of a lottery is critical to its ability to attract players. We strive to set exacting standards of personal integrity for our employees and system security for the systems that we provide to our customers, and our reputation in this regard is an important factor in our business dealings with lottery and other governmental agencies. For this reason, an allegation or a finding of improper conduct on our part, or on the part of one or more of our employees that is attributable to us, or an actual or alleged system security defect or failure attributable to us, could have a material adverse effect upon our business, financial condition, results and prospects, including our ability to retain existing contracts or obtain new or renewal contracts. See Item 3, "Legal Proceedings - "Brazilian Legal Proceedings - The CEF Contract Proceedings" for a discussion of a civil action initiated by federal attorneys with Brazil's Public Ministry against GTECH Brazil and two of our former employees, among others; a criminal action recommended by federal attorneys with Brazil's Public Ministry alleging employee misconduct by two of our former employees, among others, and a related SEC investigation; and other legal proceedings involving our contractual relationship with CEF. 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. We purchase most of the parts, components and subassemblies necessary for our terminals from outside sources. We assemble these parts, components and subassemblies into finished products in our manufacturing facility. While most of the parts, components and subassemblies can be purchased through more than one supplier, we currently have approximately three material sole source vendors. We believe that if a supply contract with one of these vendors were to be terminated or breached, we would be able to replace the vendor. However, it may take time to replace the vendor under some circumstances and any replacement parts, components or subassemblies may be more expensive, which could reduce our margins. Depending on a number of factors, including the level of the related part, component or subassembly in our inventory, the time it takes to replace a vendor may result in a delay in our implementation of a lottery system for a customer. Generally, if we fail to meet our performance schedules under our contracts, we may be subject to substantial penalties or liquidated damages, or even contract termination. OUR NON-LOTTERY VENTURES, WHICH ARE AN INCREASINGLY IMPORTANT ASPECT OF OUR BUSINESS, MAY FAIL. Our business prospects and future success depend, in part, upon our ability to expand our transaction processing services into complementary and parallel markets outside of our core lottery market. In fiscal 2005, commercial services transaction processing represented approximately 7% of our total revenues and non-lottery gaming represented approximately 6% of our total revenues. By way of comparison, in fiscal 2003, approximately 5% of our total revenues were derived from commercial services transaction processing, and approximately 2% of our total revenues were derived from non-lottery gaming. With our acquisition in May 2003 of a controlling equity interest in PolCard, S.A. ("PolCard"), a leading debit and credit card merchant transaction acquirer and processor company in Poland; our acquisition in September 2004 by PolCard of BillBird S.A., a leading provider of electronic bill payment services in Poland; and our December 2004 agreement to acquire a 50% controlling equity position in Atronic, a video slot manufacturer that is a market lender in Europe, Russia, and Latin America, with a presence in the United States, we expect non-lottery ventures to become increasingly significant to our overall financial performance. Because we have less experience in non-lottery markets than we have in our core lottery market, our non-lottery ventures present an enhanced element of risk for us. Our non-lottery ventures outside the United States are particularly sensitive to the economic and political risks of doing business in these countries, including foreign currency exchange risks. In addition, our ability to complete the acquisition of a 50% controlling equity interest in Atronic, and otherwise to expand into non-lottery gaming markets, is dependent upon our success in obtaining required non-lottery gaming licenses in numerous jurisdictions. As non-lottery services start to represent a more significant portion of our operations, the failure of one or more of our non-lottery ventures could have a material effect on our business, financial condition, results and prospects. SIGNIFICANT DEVELOPMENT SINCE THE START OF FISCAL 2005 LOTTERY CONTRACT AWARDS Since the start of fiscal 2005 (which ended on February 26, 2005), we received a number of contract awards and extensions from lottery authorities. NEW ONLINE CUSTOMERS. During fiscal 2005, we acquired nine new online customers. In May 2004, we acquired eight new online lottery customers upon completion of our acquisition of all of the shares of privately-held Leeward Islands Lottery Holding Company, Inc. ("LILHCo"), a lottery operating company headquartered on the Caribbean Islands of Antigua and St. Croix. The enterprise purchase price that we paid in cash for LILHCo was approximately $40 million. LILHCo holds long-term licenses to operate lotteries in Antigua and Barbuda; Anguilla; St. Kitts/Nevis; St. Maarten, Saba and St. Eustatius; and Turks and Caicos, and operates lotteries in Barbados, Bermuda and the U.S. Virgin Islands. In addition, LILHCo holds a video lottery terminal ("VLT") license in Turks and Caicos, and has received confirmation that its existing license in St. Kitts/Nevis allows for the installation of video lottery gaming. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." In September 2004 the Government Lottery Office of Thailand announced that Loxley GTECH Technology Co. Ltd. ("LGT") had been chosen, following a competitive procurement, as the preferred bidder to provide equipment and services for a national online lottery in Thailand. LGT is a company that we formed in joint venture with Loxley Public Company Limited, a leading trading and telecommunications conglomerate in Thailand. We own a 49 percent equity interest in LGT and Loxley Public Company Limited owns the remaining 51 percent equity interest in LGT. We will be the principal provider of technology and services to LGT. The Thailand lottery authority and LGT remain in contract negotiations to finalize the terms and conditions of this award. NEW CONTRACTS WITH, AND EXTENSIONS AND ORDERS BY, EXISTING CUSTOMERS. Since the start of fiscal 2005, we have also been awarded new contracts by, or have received contract extensions or orders from, a number of our existing customers. In September 2004, following a competitive procurement, we entered into a six-year integrated services contract with Pronosticos para la Asistencia Publica ("Pronosticos"), the Mexican lottery authority, to provide equipment and services for a new online lottery system and an associated telecommunications network. Under the terms of the new contract, we will replace Pronosticos's existing lottery system with new central system hardware and add our ES Connect(TM) software, which provides IP message routing, translation and terminal management. We will also provide Pronosticos with approximately 4,800 Altura(R) terminals, 3,200 Altura(R) LVT Plus Terminals, and ongoing services. Implementation of this contract has been suspended pending resolution of administrative and legal challenges by two of our competitors to Pronosticos' award of this contract. In December 2004, following a competitive procurement, we entered into a seven-year facilities management agreement with the Missouri lottery authority to provide a new online lottery central system and ongoing services. Under the terms of this contract, we will provide the Missouri lottery authority with our Enterprise Series(TM) architecture, and approximately 6,000 Altura(R) terminals, a communications network and comprehensive services. We expect sales to commence under the Missouri lottery authority's new system in July 2005. Several of our fiscal 2005 contract developments were in respect to product sales. In June and July 2004, we announced that Organizaciun Nacional de Ciegos Espanoles ("ONCE") had exercised options under its existing agreement with us to purchase a total of 12,000 additional handheld lottery terminals. ONCE, also known as the Spanish National Organization for the Blind, is authorized by the Spanish government to administer lottery and wagering games in Spain. In November 2004, following a competitive procurement, we were selected as the preferred bidder by Societe de la Loterie de la Suisse Romande, the Swiss lottery authority, to provide a new integrated online and instant-ticket lottery system, terminals, and communications network. We are currently finalizing the terms of the product sale agreement documenting this award. In December 2004, we entered into a product sale agreement with the German lottery authority Lotterie-Treuhandgesellschaft mbH Thuringen ("Thuringen Lottery") pursuant to which we will provide a new online and instant-ticket lottery central system, and terminals. We have also agreed to provide to Thuringen Lottery ongoing services (including central system and terminal maintenance, retailer training and field services) as part of these arrangements. In December 2004 we also entered into a five year product sale agreement with Veikkaus Oy, the operator of the Finnish national lottery, to replace the Finnish lottery authority's existing gaming system with an integrated system featuring our Enterprise Series(TM) architecture and Altura(R) terminals. The new integrated system that we are providing will include an interactive gaming solution as well as online and instant ticket lottery systems. We will provide ongoing services to the Finnish lottery authority over the term of the agreement. This contract award followed a competitive procurement. In February 2005, following a competitive procurement, we were selected as the lead bidder by the New Zealand Lotteries Commission to begin negotiations of the terms of a product sale agreement under which we would provide the New Zealand lottery authority with a new integrated online and instant lottery system, including new terminals. We expect to finalize this agreement with the New Zealand lottery authority by June 2005. During fiscal 2005, we received several awards to provide instant-ticket vending machines, which are also known as instant ticket dispensing machines and lottery product vending machines ("ITVMs"), to our existing customers. In June 2004, we entered into a three-year contract to provide the Washington State lottery authority with ITVMs and ongoing maintenance and support services. In June 2004, the Virginia lottery authority awarded a seven-year contract to Oberthur Gaming Technologies Corporation ("OGT") to provide lottery goods and services to the Virginia lottery authority commencing in June 2005. We have subcontracted with OGT to provide to the Virginia lottery authority new ITVMs and to manage the warehousing and distribution of instant tickets. In July 2004 we entered into a five-year contract to provide to the Illinois lottery authority new ITVMs and ongoing maintenance and support services. Finally, in September 2004, we entered into a three-year contract to provide the Maine lottery authority with ITVMs. Each of these awards followed a competitive procurement. During fiscal 2005, the lottery authorities of Oregon, Minnesota and South Australia and Milli Piyango and Oeuvre Nationale de Secours Grande-Duchesse Charlotte, our lottery customers in Turkey and Luxembourg, respectively, exercised options to extend the terms of their online contracts with us. Moreover, the Colorado lottery authority, which, following a competitive procurement, had selected another vendor in October 2002 to provide equipment and services for a new lottery system to become operational upon the termination of our online contract in October 2004, twice exercised its right to extend our contract for a total of 180 days in order to provide the other vendor additional time beyond the previously established deadline to convert the system. In addition, we entered into contract extensions with the lottery authorities of Arizona and New Mexico to provide new products and continued services for the lotteries' ITVMs. In May 2004, we were notified by our customer, Loteria Electronica de Puerto Rico, of its intent to negotiate a contract to provide a new online lottery system and an associated telecommunications network with another vendor to take effect upon the expiration of our contract in March 2005. OTHER PRODUCTS AND SERVICES Since the start of fiscal 2005, we entered into a number of agreements, and announced a number of other developments, respecting products and services outside of our traditional online lottery product offerings. VIDEO LOTTERY AND GAMING. In April 2004, we completed the acquisition of privately-held Spielo Manufacturing, Inc. ("Spielo"), a leading provider of video lottery terminals ("VLTs") and related products and services to the global gaming industry for an all-cash purchase price of approximately $150 million. In addition, we paid Spielo shareholders approximately $10.7 million out of a potential maximum earn-out of up to $35 million which the former Spielo shareholders are entitled to receive in the 18 months following the closing, based upon Spielo achieving certain VLT installation objectives in New York, and separately, a working capital adjustment of approximately $1.5 million. We believe that by acquiring Spielo we will be better able to deliver a complete, integrated VLT solution to our existing and potential customers with a single point of contact and accountability. In July 2004, we signed a new integrated services contract to provide a complete video lottery solution, including a central system, VLTs, and a communications network, and related services to Supreme Ventures Limited in Jamaica. Under the term of this new contract, we will provide Supreme Ventures with our Enterprise Series(TM) video lottery central system solution, an initial installation of approximately 125 VLTs, and such additional terminals as Supreme Ventures may elect to order over the life of the contract. This contract is coterminous with our existing online lottery contract with Supreme Ventures, which is scheduled to expire in January 2011. In October 2004, following a competitive procurement, and subject to the negotiation and execution of a definitive product sale agreement, we were selected by Atlantic Lottery, the Canadian lottery authority ("ALC") to replace ALC's existing video lottery central system, currently provided by another vendor, with our Enterprise Series(TM) video central system. The new system will monitor the integrity and security of over 9,000 VLTs currently installed in age-controlled establishments throughout New Brunswick, Prince Edward Island, Nova Scotia, Newfoundland and Labrador. We continue to negotiate with the ALC the terms and conditions of the definitive product sale agreement reflecting the ALC award. In December 2004, we entered into an agreement with the owners of the privately-held Gauselmann Group ("Gauselmann"), to acquire a 50 percent controlling equity interest in the Atronic group of companies ("Atronic") owned by Gauselmann. Atronic is a video slot manufacturer that is a market leader in Europe, Russia and Latin America with a presence in the United States. Completion of this transaction, which is contingent upon obtaining required regulatory and gaming license approvals and the satisfaction of other closing conditions, is expected to take place in December 2006. The acquisition agreement provides that the purchase price payable by us at the closing shall be equal to eight times Atronic's earnings before interest, tax, depreciation, and amortization for its fiscal year ending December 31, 2006. In addition, during the twelve months following the closing, we may be obligated to pay additional amounts with respect to our acquisition of a 50 percent controlling interest in Atronic if Atronic's performance during calendar 2007 exceeds specified thresholds. The acquisition agreement also provides that we have the option to purchase from Gauselmann and Gauselmann has the right to sell to us, its remaining 50 percent interest in Atronic commencing in 2012, and under certain circumstances prior to 2012. We believe that our alliance with Gauselmann will create a strong new competitor in world gaming markets, and will, in addition, broaden our government-sponsored game and systems offerings and strengthen our Spielo subsidiary. We believe that the Atronic transaction represents the next logical step for us towards achieving our long-term strategic objectives within the gaming markets that we have targeted. In February 2005, AB Svenska Spel, the Swedish lottery authority, agreed to purchase from Spielo 2,000 next generation wide area VLTs to be deployed commencing in September 2005. During fiscal 2005, Spielo was also selected to provide the Oregon lottery authority with approximately 2,000 PowerStation5(TM) VLTs. COMMERCIAL SERVICES. In September 2004, our majority-owned commercial services subsidiary, PolCard S.A., completed the acquisition of all of the shares of privately-held BillBird S.A., the leading provider of electronic bill payment services in Poland, for a total purchase price of approximately $6 million. This acquisition advances our commercial services market objective of offering a full product suite, including debit and credit transaction processing, card services, electronic bill payments, and prepaid mobile phone top-ups. In addition, during fiscal 2005 we commenced the sale of mobile phone top-ups through lottery terminals in Barbados, Trinidad and Tobago and Lithuania. Lottery terminals that went into service during fiscal 2005 in Trinidad and Tobago permit bill payment transactions, as well as the sale of mobile phone top-ups. NEW PRODUCT OFFERINGS AND DEVELOPMENTS. In March 2004, we expanded our lottery game offerings by entering into separate licensing agreements with Hasbro Properties Group, the intellectual property arm of Hasbro, Inc. (granting us rights to develop and distribute in the United States, Canada and Mexico, select lottery products featuring Hasbro's Monopoly(R) and Battleship(R) brands), and New Vision Gaming (granting us exclusive rights to offer the flagship games Players Choice Poker(R) and Worldwide Poker.(R)) Both agreements permit the development and distribution of the licensed games through various sales channels in addition to traditional online and instant ticket lottery. In May 2004, HotTrax,(R) a new three dimensional lottery game that we developed, debuted in Rhode Island. This race-based monitor game provides players with an opportunity to place every four or five minutes a variety of wagers on the finishing order of racecars. In February 2005, we obtained a five-year exclusive licensing agreement giving us the right to utilize the names, likenesses, and signatures of premier racecar drivers in connection with our HotTrax(R) game. In July 2004, we announced the development of GamePoint,(TM) our all-in-one instant and online lottery terminal solution. The GamePoint terminal, which dispenses both instant and online tickets, is completely self-contained and provides a secure and player-friendly opportunity for the sale of instant and online lottery products. In September 2004, Spielo introduced new multi-denomination and low-denomination games for its Aura(R) upright and slant top VLTs. In December 2004, the Multi-State Lottery Association ("MUSL") selected us, following a competitive procurement involving four other bidders, to supply equipment, software, services and a communications network for the first ever multi-vendor, multi-state video lottery wide area progressive solution. Our unique and patent-pending multi-vendor concept allows VLTs from multiple vendors to be linked in a single progressive game, and affords MUSL great flexibility in providing players with their favorite games within a professional environment. We anticipate that the MUSL wide area progressive solution will commence operations in nine facilities in Rhode Island, Delaware and West Virginia. MUSL is a non-profit, government-benefit association owned and operated by its member lotteries and has responsibility for PowerBall(R). LOTTERY INDUSTRY We base statements relating to the lottery industry contained in this report on information compiled by us, or derived from independent public sources which we believe to be reliable. No assurance can be given, however, regarding the accuracy of such statements. In general, there is less publicly-available information concerning the international lottery industry than the lottery industry in the United States. Lotteries are operated by state and foreign governmental authorities and their licensees in over 200 jurisdictions worldwide. Governments have authorized lotteries primarily as a means of generating non-tax revenues. In the United States, lottery revenues are frequently designated for particular purposes, such as education, economic development, conservation, transportation and aid to the elderly. Many states have become increasingly dependent on their lotteries as revenues from lottery ticket sales are often a significant source of funding for these programs. Although there are many types of lotteries in the world, it is possible to categorize government authorized lotteries into two principal groups: online lotteries and off-line lotteries. An online lottery is conducted through a computerized lottery system in which lottery terminals are connected to a central computer system. An online lottery system is generally utilized for conducting games such as lotto, sports pools, keno and numbers, in which players make their own selections. Off-line lotteries feature lottery games which are not computerized, including traditional off-line lottery games and instant-ticket games. Traditional off-line lottery games, in which players purchase tickets which are manually processed for a future drawing, generally are conducted only in international jurisdictions. Instant-ticket games, in which players scratch off a coating from a pre-printed ticket to determine if it is a winning ticket, are conducted both internationally and in the United States. In general, online lotteries generate significantly greater revenues than both traditional off-line lottery games and instant-ticket games. In addition, there are several other advantages to online lotteries as compared to traditional off-line lotteries. Unlike traditional off-line lottery games, wagers can be accepted and processed by an online lottery system until minutes before a drawing, thereby significantly increasing the lottery's revenue in cases in which a large prize has attracted substantial wagering interest. Online lottery systems also provide greater reliability and security, allow a wider variety of games to be offered and automate accounting and administrative procedures which are otherwise manually performed. Typically, approximately 50 percent of the gross revenues of an online lottery in the United States is returned to the public in the form of prizes. Approximately 35 percent is used by the state to support specific public programs or as a contribution to the state's general funds. The remaining 15 percent is generally used to fund the operations of the lottery, including the cost of advertising, sales commissions to point-of-purchase retailers and service fees to vendors such as us. According to La Fleur's 2003 and 2005 World Lottery Almanacs, from 1972 through 2004, total annual lottery ticket sales in the United States grew from approximately $295.0 million to approximately $44.9 billion, although, in recent years, as the United States lottery industry has matured, the rate of lottery sales growth has moderated and certain of our customers have from time-to-time experienced a downward trend in sales. See "Certain Factors That May Affect Future Performance - Slow growth or declines in sales of online lottery goods and services could lead to lower revenues and cash flow," above. There are currently 41 jurisdictions operating online lotteries in the United States. Implementation of lotteries in other jurisdictions will depend upon successful completion of legislative, regulatory and administrative processes. Outside the United States, government operated or licensed lotteries, many of which are off-line, have a long history. The international online lottery industry has experienced significant growth. Since 1977, when there were no online lotteries operating outside of the United States, 122 international jurisdictions have implemented online lottery systems. A number of other international jurisdictions, principally in Europe, Asia-Pacific, and Latin America, are currently considering the implementation of online lotteries. ONLINE LOTTERY BUSINESS ONLINE LOTTERY CONTRACTS OVERVIEW. We generally conduct business under one of two types of contractual arrangements which are described in more detail below: Facilities Management Contracts and Product Sales Contracts. Under a typical Facilities Management Contract, 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 to be paid to us directly from the lottery authority based on a percentage of a lottery's gross online and instant ticket sales. Under Product Sales Contracts, we construct, sell, deliver and install a turnkey online lottery system or lottery equipment and license the computer software for a fixed price, and the lottery authority subsequently operates the lottery system. The collection of lottery monies, the selection of winners, the financial responsibility for the payment of prizes and the qualification of retail sales agents are usually the sole responsibility of the lottery authority in each jurisdiction in which we operate a lottery. The United Kingdom's National Lottery, Taiwan's Public Welfare Lottery and the South African National Lottery provide important exceptions to the general rule, in that in each case a licensee to whom we supply goods and services (rather than the lottery authority) operates all aspects of the respective lottery with the exception of proceeds allocation. With respect to fiscal 2005, approximately 72% of our revenues were service revenues earned under our Facilities Management Contracts; approximately 15% of our revenues were product sales revenues earned under Product Sales Contracts; and approximately 13% of our revenues were attributable to the provision of nonlottery goods and services. FACILITIES MANAGEMENT CONTRACTS. Our Facilities Management Contracts typically require us to construct, install and operate the lottery system for an initial term, which is typically at least five to seven years, and usually contain options permitting the lottery authority to extend the contract under the same terms and conditions for one or more additional periods, generally ranging from one to five years. In addition, our customers occasionally renegotiate extensions on different terms and conditions. Our revenues under Facilities Management Contracts are generally a variable amount of monthly or weekly service fees which are paid to us directly from the lottery authority based on a percentage of such lottery's gross online and instant ticket sales. The level of lottery ticket sales within a given jurisdiction is determined by many factors, including population density, the types of games played and the games' design, the number of terminals, the size and frequency of prizes, the nature of the lottery's marketing efforts and the length of time the online lottery system has been in operation. Under our Facilities Management Contracts, we typically retain title to the lottery system and typically provide our customers with the services necessary to operate and manage the lottery system. We install and commence operations of a lottery system after being awarded a Facilities Management Contract and, following the start-up of the lottery system, we are responsible for all aspects of the system's operations. We typically operate lottery systems in each jurisdiction on a stand-alone basis through the installation of two or more dedicated central computer systems, although in a few instances several jurisdictions have shared the same central system. In addition, in most jurisdictions we employ a work force consisting of a site director, marketing personnel, computer operators, communications specialists and customer service representatives who service and maintain most aspects of the system. Under certain of our Facilities Management Contracts the lottery authority has the right to purchase our lottery system during the contract term at a predetermined price, which is calculated so that it exceeds the net book value of the system at the time the right is exercisable. In addition, some of our lottery contracts permit the lottery authority to acquire title to our system-related equipment and software during the term of the contract or upon the expiration or earlier termination of the contract, in some cases (i.e., were we to materially breach or be unable to perform under certain circumstances) without paying us any compensation related to the transfer of that equipment and software to the lottery authority. Our role, if any, with respect to the continued operation of a lottery system in the event of the exercise of such a purchase option generally is not specified in such contracts and thus would be subject to negotiation. Under many of our Facilities Management Contracts, the lottery authority also has the option to require us to install additional terminals and/or add new lottery games. Such installations may require significant expenditures by us. However, since our revenues under such contracts generally depend on the level of lottery ticket sales, such expenditures have generally been recovered through the revenues generated by the additional equipment or games and revenues from existing equipment. Under a number of our lottery contracts, in addition to constructing, installing and operating the online lottery systems in these jurisdictions, we are providing a wide range of support services and equipment for the lottery's instant-ticket games, such as marketing, distribution and automation of validation, inventory and accounting systems, for which we receive fees based upon a percentage of the sales of the instant-ticket games. Revenues from Facilities Management Contracts are accounted for as Service Revenue in our Consolidated Income Statements. Unless otherwise indicated, the table below sets forth the lottery authorities with which we had Facilities Management Contracts and fully installed, operational lottery systems as of February 26, 2005, and as to which we are the sole supplier of central computers and terminals and material services. The table also sets forth information regarding the term of each contract and, as of February 26, 2005, the approximate number of terminals installed in each jurisdiction.
Approximate Date of Current Number of Lottery Commencement of Date of Expiration of Extension Jurisdiction Terminals Installed (1) Current Contract Current Contract Term Options* -------------- ----------------------- ---------------- --------------------- --------- United States: Arizona 2,500 9/99 9/06 - California 19,800 10/03 10/09 4 one-year Colorado (2) 2,450 3/95 4/05 - D.C. (3) 600 6/99 11/09 - Florida 11,250 1/05 3/11 2 two-year Georgia 8,150 9/03 9/10 - Idaho 750 2/99 2/07 - Illinois 7,100 4/00 10/07 1 one-year Kansas 1,950 7/02 6/08 - Kentucky 2,800 4/97 6/08 - Louisiana 2,750 6/97 6/10 - Michigan 9,250 1/98 1/09 - Minnesota 3,150 2/03 2/11 2 one-year Missouri 3,900 12/04 6/05 (5) New Jersey 6,050 6/96 6/06 - New Mexico 1,100 6/96 11/08 - New York 15,950 3/02 3/07 3 one-year Ohio 7,350 6/01 6/05 2 two-year Oregon 2,750 6/98 6/08 - Rhode Island 1,050 7/03 6/23 - Tennessee 4,400 1/04 4/11 - Texas 16,750 8/02 8/11 - Washington 2,800 9/95 6/06 -
Approximate Date of Current Number of Lottery Commencement of Date of Expiration of Extension Jurisdiction Terminals Installed (1) Current Contract Current Contract Term Options* -------------- ----------------------- ---------------- --------------------- --------- Wisconsin 3,100 6/04 6/11 2 one-year International: Anguilla -LILHCo 9 10/97 10/07 1 ten-year Antigua/Barbuda -LILHCo 54 1/00 1/10 1 ten-year Argentina -Loteria National Sociedad del Estado(4) 800 11/93 1/07 - -Boldt IPLC (4) 2,950 11/99 11/09 - Barbados -T.L. Lotteries (6) 200 10/94 5/05 - -LILHCo (6) 103 12/01 12/11 1 ten-year Bermuda automatic -LILHCo 1 - - annual renewal Brazil -National Lottery (7) 21,600 5/00 5/05 - -Minas Gerais 800 10/94 11/06 - -Santa Catarina 100 4/02 4/06 1 one-year China -Beijing Welfare Lottery 1,650 4/04 12/12 - Colombia -ETESA (8) 4,100 12/99 1/11 1 five-year Czech Republic -SAZKA 6,900 10/92 12/17 - Ireland -An Post Nat'l Lottery Company 2,050 6/02 12/08 (9) Jamaica -Supreme Ventures Limited 900 11/00 01/11 1 ten-year Luxembourg (10) -Loterie Nationale 350 6/01 10/12 -
Approximate Date of Current Number of Lottery Commencement of Date of Expiration of Extension Jurisdiction Terminals Installed (1) Current Contract Current Contract Term Options* -------------- ----------------------- ---------------- --------------------- --------- Mexico -Pronosticos Para La Assistencia Publica 7,450 (11) (11) (11) Morocco -La Societe de Gestion de la Loterie Nationale and La Marocaine des Jeux et Les Sports 1,400 8/99 4/09 1 one-year Poland -Totalizator Sportowy 10,800 5/01 5/11 1 six-month Puerto Rico -Loteria Electronica de Puerto Rico 1,850 3/99 3/05 (12) Slovak Republic -TIPOS a.s. 1,500 3/96 12/11 - South Africa (13) -National Lottery 7,850 7/99 4/07 1 one-year Spain -L'Entitat Autonoma de Jocs I Apostes de la Generalitat de Catalunya 2,500 4/04 10/05 (14) - Sri Lanka -Mahapola Higher Education Scholarship Trust Fund 300 6/04 6/14 1 five-year St. Kitts/Nevis -LILHCo 50 4/96 4/06 1 ten-year St. Maarten/Saba/St. Eustatius -LILHCo 40 1/97 1/07 1 ten-year Taiwan -Taipei Bank (15) 6,800 11/01 12/06 -
Approximate Date of Current Number of Lottery Commencement of Date of Expiration of Extension Jurisdiction Terminals Installed (1) Current Contract Current Contract Term Options* -------------- ----------------------- ---------------- --------------------- --------- Trinidad & Tobago -National Lotteries Control Board 550 12/93 7/06 1 three-year Turkey -Turkish National Lottery (4) 3,900 2/96 11/05 (16) Turks & Caicos -LILHCo - 10/04 10/14 1 ten-year United Kingdom -The National Lottery (17) 26,850 1/02 1/09 - Ukraine -Ukrainian National Lottery 2,600 8/00 12/10 - U.S. Virgin Islands -LILHCo 81 1/02 1/12 2 five-year
--------------------------------------------------- *Reflects extensions available to the lottery authority under the same terms as the current contract. Lottery authorities occasionally negotiate extensions on different terms and conditions. (1) Total does not include instant-ticket validation terminals or instant ticket vending machines. (2) The Colorado lottery authority selected another vendor to provide equipment and services after the Colorado lottery authority's contract expired in October 2004. Two extensions to the contract have extended the term through April 2005. (3) Operated by Lottery Technology Enterprises, a joint venture in which we have a 1% interest, and to which we supply lottery goods and services. (4) Under these contractual arrangements (which we formerly referred to as "Operating Contracts"), the lottery authorities purchased the lottery system and related software license from us at the respective start of the contracts. (5) A seven year contract extension has been signed that will, upon termination of the current term, extend the term of the contract through June 2012. (6) The entities operating the Barbados lotteries are in the process of consolidation. Upon completion of the consolidation, GTECH will enter into a contract to provide lottery services with the consolidated entity which is expected to occur in May 2005. (7) Operated by GTECH Brasil Ltda. Holdings, S.A., a Brazilian company in which we own all voting stock. The term of our contract runs until May 2005, with Caixa Economica Federal, the operator of the National Lottery, having the right to extend the term until May 2006 upon its existing terms and conditions. We are currently negotiating an extension to the contract. See "Item 3, "Legal Proceedings" below. (8) Our contract with the Colombia lottery authority is not a true facilities management contract in that title to the equipment vests in the Colombia lottery authority at the end of the term. (9) Our contract with the Ireland lottery authority may be extended for any period mutually acceptable to us and the Ireland lottery authority. (10) The Luxembourg lottery authority can extend the software license granted by us for up to 10 years after the end of the initial term and any extensions of the contract. (11) Our contract with the Mexico lottery authority is not a true facilities management contract. Title to all equipment, which initially had been supplied under lease, has passed to the lottery authority pursuant to the terms of our agreement. We provide maintenance and other services if requested by the lottery authority. In September 2004, GTECH signed a contract with Pronosticos para la Asistencia Publica to provide equipment and services to a new online lottery system and associated telecommunications network in Mexico. Implementation of this contract has been suspended pending resolution of administrative and legal challenges by two of our competitors to Pronosticos's award to us of this contract. (12) The Puerto Rico lottery authority selected another vendor to provide equipment and services after the Puerto Rico lottery authority's contract with us terminates in March 2005. (13) Operated by Uthingo consortium, in which we are a 10 percent equity owner. (14) We have been advised that this lottery authority has selected another vendor to supply lottery goods and services upon the termination of our contract in October 2005. (15) Lottery Technology Services Corporation ("LTSC"), a consortium in which we own a 44% indirect interest, entered into a Commission Agreement with the Bank of Taipei to operate the Taiwan Public Welfare Lottery. ACER, Inc. indirectly owns the other 56% of LTSC. We supply terminals to LTSC and provide to LTSC central system maintenance, software support and consulting services pursuant to service and supply agreements. (16) The term of the contract with the Turkey lottery authority renews for successive one-year extension terms unless either party gives timely notice of non-renewal. In addition, the Turkey lottery authority has the option to assume responsibility for the provision of certain lottery services at any time after the second anniversary of system start-up. (17) Operated by Camelot Group plc, a consortium, on a facilities management basis. PRODUCT SALES CONTRACTS. Under Product Sale Contracts, we construct, sell, deliver and install turnkey lottery systems or lottery equipment and license the computer software for a fixed price, and the lottery authority subsequently operates the lottery system. We also sell additional terminals and central computers to expand existing systems and/or replace existing equipment under Product Sales Contracts. In connection with our Product Sales Contracts, we generally design the lottery system, train the lottery authority's personnel and provide other services required to make and keep the system operational. We also generally license our software to our customers for a fixed additional fee. Historically, product sales revenues have been derived from the installation of new online lottery systems, installation of new software and the sales of lottery terminals and equipment in connection with the expansion of existing lottery systems. The size and timing of these transactions at times has resulted in variability in product sales revenues from quarter to quarter. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." The table below lists certain of our direct and indirect customers that since March 1, 2000 have purchased (or have agreed to purchase) from us new online or video lottery systems, software and/or terminals and equipment in connection with the expansion or replacement of existing lottery systems. Australia --Lotteries Commission of New South Wales Australia --Western Australia Lotteries Commission
Belgium --Loterie Nationale de Belgique California --California State Lottery Canada --Alberta Gaming & Liquor Commission --British Columbia Lottery Corporation --Western Canada Lottery Corporation China --Beijing Welfare Lottery Center Finland --Veikkus Oy France --La Francaise des Jeux Germany --WestLotto --Sachsische Lotto - Gmbh --Lotterie Treuhandgesellschaft mbH Thuringen Israel --Mifal Hapayis Luxembourg --Loterie Nationale Massachusetts --Massachusetts State Lottery Commission Netherlands --Stichting de Nationale Sport Totalisator Pennsylvania --IGT OES Online Entertainment Systems, Inc. Poland --Totalizator Sportowy Sp. Zo.o Portugal --Santa Casa de Misericordia de Lisboa Singapore --Singapore Pools (Pte) Ltd. South Africa --Uthingo Spain --Sistemas Tecnicos de Loterias del Estado --Organizacion Nacional de Ciegos Espanoles Sweden --AB Svenska Spel Switzerland --Loterie de la Suisse Romande Taiwan --Lottery Technology Services Corporation United Kingdom --The National Lottery Virginia --Virginia Lottery
VIDEO LOTTERY CONTRACTS. On April 30, 2004, we acquired Spielo Manufacturing Incorporated ("Spielo"), a leading provider of video lottery terminals ("VLTs") and related products and services to the global gaming industry. Spielo supplies video lottery terminals on a product sales basis to various lottery authorities and gaming establishments throughout the world. INSTANT TICKET VENDING MACHINE LOTTERY CONTRACTS OVERVIEW: During fiscal 2004 we acquired Interlott Technologies, Inc. ("Interlott"), a leading provider of instant ticket vending machines ("ITVMs") for the lottery industry worldwide. Similar to our online business, our ITVM business is generally conducted under one of two types of contractual arrangements which are described in more detail below: Facilities Management Contracts and Product Sales Contracts. FACILITIES MANAGEMENT CONTRACTS: Under a typical ITVM Facilities Management Contract with a lottery authority, we build to specification, install, and service ITVMs for an initial term which typically is four years. These contracts usually contain options permitting the relevant lottery authority to extend the contract under the same terms and conditions for additional periods, generally ranging from one to three years. In addition, our ITVM customers occasionally renegotiate extensions on different terms and conditions. Historically, the majority of Interlott's Facilities Management Contracts have been based on a compensation structure involving fixed monthly lease payments paid directly by the lottery authorities. However, our recent ITVM Facilities Management Contracts feature a compensation structure based upon a negotiated percentage of the ITVM instant tickets sales revenues. Under our ITVM Facilities Management Contracts, we retain title to the ITVMs, while providing our customers with necessary support services. In most of our ITVM jurisdictions we employ a dedicated work force, consisting of a Regional Service Manager, marketing personnel, and customer service representatives who help service and maintain most aspects of the ITVM program. PRODUCT SALES CONTRACTS: Under a typical ITVM Product Sales Contract, for a fixed price we construct, sell, deliver and install a turnkey ITVM system that the lottery jurisdiction subsequently operates. The table below sets forth the lottery authorities with which we currently have ITVM Facilities Management Contracts ("FMCs"). This table also provides (except where noted by footnote) historical information respecting the number of ITVMs that are currently in service, under various ITVM Product Sales Contracts ("PSCs"). Finally, the table below sets forth information regarding the term of each FMC, as well as the approximate number of ITVMs installed in each FMC jurisdiction, as of the date hereof.
DATE OF DATE OF FMC APPROXIMATE COMMENCEMENT OF EXPIRATION OF CURRENT OR NUMBER OF CURRENT FMC CURRENT FMC EXTENSION JURISDICTION PSC ITVMS IN SERVICE CONTRACT CONTRACT TERM OPTIONS ------------ --- ---------------- --------------- ------------- ------------- Arizona FMC 420 7/03 7/08 -- California PSC 3,900 N/A N/A N/A D.C. FMC 100 12/01 12/05 1 one-year Idaho PSC 195 N/A N/A N/A Illinois FMC 3,245 6/04 9/10 1 three-year Indiana FMC 1,385 1/01 3/05 -- Iowa FMC 400 1/01 3/05 -- Kentucky PSC 1,250 N/A N/A N/A Maine FMC 150 9/04 8/07 -- Maryland PSC 910 N/A N/A -- Massachusetts PSC 1,575 N/A N/A N/A Minnesota (2) 110 N/A N/A N/A Missouri FMC 630 6/01 6/08 4 one-year New Hampshire FMC 220 7/00 6/05 -- New Jersey (2) 210 N/A N/A N/A New Mexico FMC 160 5/97 6/07 -- New York FMC 4,380 5/02 7/05 -- Ohio FMC 1,500 7/03 6/05 2 two-year Oregon PSC 500 N/A N/A N/A Pennsylvania PSC 3,050 N/A N/A N/A Rhode Island (2) 100 N/A N/A N/A Texas FMC 1,400 9/03 9/06 2 one-year Virginia (1) PSC 1,600 N/A N/A N/A Washington FMC 1,010 11/04 11/07 1 three-year West Virginia PSC 110 N/A N/A N/A Wisconsin PSC 500 N/A N/A N/A
---------- (1) The Virginia Lottery entered into a seven-year contract with Oberthur Gaming Technologies Corporation (OGT) under which GTECH has subcontracted to provide new ITVMs and management of warehousing and distribution of instant tickets. (2) Represents ITVMs installed under a GTECH Facilities Management Contract. See Facilities Management Contracts table above for additional information. CONTRACT AWARD PROCESS In the United States, lottery authorities generally commence the contract award process by issuing a request inviting proposals from various lottery vendors. The request for proposals usually indicates certain requirements specific to the jurisdiction, such as the number of terminals and breadth of services desired, the particular games which will be required, particular pricing mechanisms, the experience required of the vendor and the amount of any performance bonds that must be furnished. After the bids have been evaluated and a particular vendor's bid has been accepted, the lottery authority and the vendor generally negotiate a contract in more detailed terms. Once the contract has been finalized, the vendor begins to install the lottery system. Our marketing efforts for our lottery products and services frequently involve top management in addition to our professional marketing staff. These efforts consist primarily of marketing presentations to the lottery authorities of jurisdictions in which requests for proposals have been issued. Marketing of our lottery products and services to lottery authorities outside of the United States is often performed in conjunction with licensees and consultants with whom we contract for representation in specific market areas. Although generally neither a condition of their contracts with us nor a condition of their contracts with lottery authorities, such licensees and consultants often agree with us to provide on-site services after installation of the online lottery system. After the expiration of the initial or extended contract term, a lottery authority in the United States generally may either seek to negotiate further extensions or commence a new competitive bidding process. Internationally, lottery authorities do not typically utilize as formal a bidding process, but rather negotiate proposals with one or more potential vendors. From time to time, there are challenges or other proceedings relating to the awarding of lottery contracts. ONLINE PRODUCTS AND SERVICES A significant portion 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 periodically is the subject of competitive procurement or renegotiation. Our lottery operations are dependent upon our continued ability to retain and extend our existing contracts and win new contracts. Our lottery systems consist of lottery terminals, central computer systems, systems and communications software and game software, and communications equipment which connects the terminals and the central computer systems. The systems' terminals are typically located in high-traffic retail outlets, such as newsstands, convenience stores, food stores, tobacco shops and liquor stores. Our online lottery systems control and perform the following functions: entry of wagers using a terminal's keyboard or a fully-integrated optical mark recognition reader; automatic auditing of each wager for correctness by the originating terminal; encryption and transmission of the wager and related data to the central computer installation(s); processing of each wager by the central computers, including entry of the wager on redundant systems; transmission of authorization for the originating terminal to accept the wager and print a receipt or ticket, winning ticket identification and validation; and administrative functions, including determination of prize pools and generation of management information reports. The basic functions of our systems, which are listed above, as well as various optional or custom-designed functions, are performed under internal controls designed for maximum security and minimum processing time. Security is provided through an integrated system of techniques, procedures and controls supported by hardware, software and human resources. Individual systems generally have redundant capacity at multiple levels and sophisticated software to ensure continuous service to the customer. TERMINALS We design, manufacture and provide the point-of-sale terminals used in our online lottery systems. Our model GT-101TF terminals, introduced in 1985, and our model GT-401/OI terminals, introduced in 1989, are installed in numerous jurisdictions. Our Spectra(R) terminal series (GT-401/0M, 402/0M and 403/OM), first introduced in 1989, is distinguished by its modular internal and external architecture. Our ISYS terminal series (GT-501, 502 and 503), introduced during fiscal 1996, is an integral, single-unit terminal which features modular subassemblies, high performance ticket printer and playslip reader subassemblies, an easy-to-use design, and a host of new features and technologies. During fiscal 1999, we announced the introduction of the PlayerExpress(TM) terminal, which was designed specifically for large retail environments, such as grocery stores, with numerous checkout lanes. During fiscal 1999, we also announced the launch of our Altura family of terminals. Altura, which represents the initial offering of our ninth generation of online lottery terminal, permits applications to be written in the Java programming language, enabling the rapid development of a wide variety of games that are compatible with numerous software environments. We have supplied Altura terminals to a number of our customers. The Altura LVT and Altura SST terminals are the newest additions to our Altura family of terminals. The Altura LVT, which features a compact platform, touch screen interface and expandable configuration, is designed to meet the needs of retailers with low volumes of transactions. The Altura SST, a self-service terminal, combines the functionality of instant ticket vending machines ("ITVMs") with the capability of selling online lottery products through a touch screen interface. During fiscal 2004, we expanded our self-service terminal offerings with the completion of our acquisition of Interlott Technologies, Inc. ("Interlott"), a leading provider of ITVMs for the worldwide lottery industry. Interlott's EDS-Q family of ITVMs offers flexibility and expandability (from a four to 24 game capacity) as well as the industry's first transaction processing connectivity to in-store lottery terminals and lottery authority central systems. We have received our first order for a hybrid self-service product that we have developed which we believe will combine the functionality of the ITVM and Altura SST, enabling the sale of both instant tickets and online games. During fiscal 2005, we completed the acquisition of Spielo Manufacturing Incorporated ("Spielo"), a leading provider of video lottery terminals and related products and services to the global gaming industry. We believe that this acquisition will further expand our terminal offerings. The Spielo family of terminals includes the Aura,(TM) a video lottery terminal that features a high-resolution 18" flat screen color monitor, 16-bit digital stereo sound, ergonomic design and powerful processor, and the Power Station 5,(TM) a video lottery terminal that is designed to meet the needs of bar and restaurant venues. During fiscal 2005, we announced the development of GamePoint,(TM) our all-in-one instant and online lottery terminal solution. The GamePoint terminal, which dispenses both instant and online tickets, is completely self-contained and provides a secure and player-friendly opportunity for the sale of instant and online lottery products. We are not dependent upon the use of our proprietary terminals and have the ability to integrate into our online lottery systems qualified third party terminals. SOFTWARE. We design and provide, or license from third parties, all applications solutions for our lottery systems. Our highly sophisticated and specialized software is designed to provide the following system characteristics: rapid processing, storage and retrieval of transaction data in high volumes and in multiple applications; the ability to down-line load (i.e., to reprogram the lottery terminals from the central computer installation via the communications system to add new games); a high degree of security and redundancy to guard against unauthorized access and tampering and to ensure continued operations without data loss; and a comprehensive management information and control system. Our ProSys(R) software system is based on client server architecture and provides open interfaces which allow for the integration and support of third-party and commercial modules and applications. Our latest generation software system, the Enterprise Series(TM) , is a unique, fully-open architecture that we believe provides a new industry standard for the development, deployment, integration and support of next-generation online lottery solutions, including those which permit sales of lottery products via a secure infrastructure over the Internet, without compromising the integrity of the games. The open system architecture of the Enterprise Series(TM) allows lotteries the flexibility to continuously upgrade their lottery systems, and integrate a broad spectrum of third party hardware and software solutions to achieve greater performance. In March 2003 we announced the launch of a certification process whereby third party technology vendors can be approved for integration with the Enterprise Series platform. Under our Enterprise Series certification process we have certified 4 third party vendors and 3 third party vendors are pending review. CENTRAL COMPUTERS. Each of our lottery systems contains one or more central computer sites to which the lottery terminals are connected. Our central computer systems are manufactured by Hewlett-Packard Company, Stratus Computer, Inc. and IBM Corporation. The specifications for the configuration of our central computer installations are designed to provide continuous availability, a high throughput rate and maximum security. Central computer installations typically include: redundant mainframe computers, various peripheral devices (such as magnetic storage devices, management terminals and hard copy printers), and various safety, environmental control and security subsystems (including back-up power suppliers), which are all manufactured by third parties, and a microcomputer-based communication and switching subsystem. In addition, we supply management information systems that provide lottery personnel access to important financial and operational data without compromising the security of the online system. Based upon our development of our Enterprise Series(TM), we will be able to integrate qualified third party software applications. COMMUNICATIONS. Our lottery terminals are typically connected to the central computer installations by dedicated telephone lines owned or leased by the jurisdiction in which the system is located. Due to the varying nature of telecommunications services available in lottery jurisdictions, we have developed the capability to utilize and interface with a wide range of communications technologies to provide a data communications pathway between the lottery terminals and the central computers, including UHF Radio capability (narrow-band and Spread Spectrum), GSAT/VSAT, Microwave, Integrated Services Digital Networking (ISDN), Data Over Voice (DOV), fiber optic and cellular telephone. According to industry sources that we regard as reliable, we are the largest global provider of wireless point-of-sale devices. GAMES. An important factor in maintaining and increasing public interest in lottery games is innovation in game design that aims to catch the eye and interest of potential players. In conjunction with lottery authorities, we utilize principles of demographics, sociology, psychology, mathematics and computer technology to design customized lottery games which are intended to appeal to the populations served by our lottery systems. The principal characteristics of game design include: frequency of drawing, size of pool, cost per play and setting of appropriate odds. We believe that our expertise in game design has enhanced the marketing of our lottery systems and has contributed to increases in the revenues of some of our customers. Keno(TM), an online game which we, together with the Lotteries Commission of South Australia, first introduced in 1990, exemplifies how innovative lottery games can help our lottery customers maintain or increase public interest in lottery games and thereby generate additional revenues. Keno(TM), features online drawings as often as every four minutes and is currently offered by 24 of our customers. We currently have a substantial number of variations of lottery games in our software library and new games under development. We believe that this game library and the "know how" and experience accumulated by our professionals since our inception make it possible for us to meet the requirements of our customers for specifically tailored games on a timely and comprehensive basis. During fiscal 2005, we entered into agreements with Hasbro Properties Group, the intellectual property development arm of Hasbro, Inc. ("Hasbro"), and New Vision Gaming, a company with extensive casino game development experience ("New Vision"), that we believe will further strengthen our lottery game content library. Under the Hasbro agreement, Hasbro grants to us a license to develop and distribute select lottery products featuring Hasbro's Monopoly(TM) and Battleship(TM) brands in the United States, Canada and Mexico, while our agreement with New Vision permits us to offer on an exclusive basis two of New Vision's flagship games. In February 2005, we obtained a five-year exclusive licensing agreement giving us the right to utilize the names, likenesses, and signatures of premium racecar drivers in connection with the HotTrax game. During fiscal 2005, we introduced HotTrax,(R) a new three dimensional lottery game that we developed, in Rhode Island. This race-based monitor game provides players with an exciting opportunity to place every four or five minutes a variety of wagers on the finishing order of racecars. MARKETING. In United States jurisdictions in which we have been awarded a lottery contract, we are frequently asked to assist the lottery authority in the marketing of lottery games to the public. Such assistance generally includes advice with respect to game design, and promotion and development and distribution of terminals and advertising programs. As part of such assistance, we developed "GMark," a computerized marketing analysis system used to determine favorable locations for new lottery terminals. The lottery authorities of California, Florida, Georgia, Illinois, Kansas, Missouri, New York, Ohio, Rhode Island, Texas and Washington currently utilize GMark systems, and many customers contact the Market Research Group from time to time to obtain GMark services. WARRANTY. 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. NON-LOTTERY COMMERCIAL SERVICES While transaction processing services for the online lottery industry remains our core service offering, we have in recent years undertaken to capitalize on the investments that we have made in secure, high-volume transaction processing technology through development of additional applications, such as financial or retail transaction processing. During fiscal 2005, revenues from non-lottery commercial services accounted for approximately 7% of our consolidated revenues. In May 2000, we signed a contract with Caixa Economica Federal, the operator of Brazil's National Lottery, to include additional financial transaction services (including bill and tax payment, social security contribution and traditional banking transaction services) over our dedicated network infrastructure. See Item 3, "Legal Proceedings - Brazilian Legal Proceedings," below. We are party to agreements with more than 700 retailers in Chile to provide electronic bill payment services at retail outlets throughout the country. During fiscal 2003, we entered into an agreement with Supreme Ventures Limited, a licensee operating certain online games in Jamaica, and Mossel Jamaica Limited, a cellular telephone service provider in Jamaica ("Digicel") to provide Digicel with a non-exclusive distribution network for the electronic sale of personal identification numbers for cellular phone usage in Jamaica, thus providing customers in Jamaica with the ability to place cellular telephone calls using purchased minutes. During fiscal 2004, we acquired a controlling equity position in PolCard S.A., a leading debit and credit card merchant transaction acquirer and processor in Poland, and were awarded a two-year contract extension by the Idaho Department of Fish and Game to continue to provide products and services to operate Idaho's fish and game licensing system through December 31, 2006. During fiscal 2005, PolCard completed the acquisition of BillBird S.A., a leading provider of electronic bill payment services in Poland. PRODUCT DEVELOPMENT We devote substantial resources in order to enhance our present products and systems and develop new products. In fiscal 2005, we spent approximately $52.6 million on research and development, as compared to $57.3 million in fiscal 2004, and $42.9 million in fiscal 2003. INTELLECTUAL PROPERTY Historically, we generally have not sought to obtain patents on our products, believing that our technical "know-how," trade secrets and the creative skills of our personnel would be of substantially more importance to our success than the benefit which patent protection ordinarily would afford. As we continue to advance the development of new technological solutions, we have decided to pursue comprehensive intellectual property protection, including patents where appropriate, for these solutions. We are currently pursuing protection of some of our newest advances in technology and gaming, including our Enterprise Series(TM), a unique, fully-open, integrated solution which includes the ability to distribute lottery games via a secure infrastructure over the Internet, without compromising the integrity of the games. We have obtained patent protection in certain of our key business methods in the areas of infrastructure systems, terminal improvements and creative game design. These use-related patents will provide legal protection in the U.S. for the next 18 to 20 years. PRODUCTION, ASSEMBLY AND COMPONENTS We purchase most of the parts, components and subassemblies necessary for our terminals and other products from outside sources. We assemble these parts, components and subassemblies into finished products in our manufacturing facility where we also conduct all of our quality testing. We offer central systems manufactured by Hewlett-Packard Company, Stratus Computer, Inc. and IBM Corporation for our lottery systems. We do not manufacture any central system components. We have approximately three material sole source vendors. The loss of any of those vendors might result in material additional costs and/or manufacturing delays. BACKLOG The backlog of our orders for sales of our products, which are supported by signed contracts with our customers and which are believed by us to be firm, amounted to approximately $143.7 million as of February 26, 2005, as compared to a backlog of approximately $166.7 million as of February 28, 2004. The decrease in the backlog is due to a lower level of product sales expected to be consummated in fiscal year 2006. Approximately $79.5 million, or 55.3% of the backlog at February 26, 2005, is expected to be filled during fiscal 2006. COMPETITION The online lottery industry has faced increased competition in recent years for the consumers' entertainment dollar, including from a proliferation of destination gaming venues, and an increased availability of Internet gaming opportunities. In addition, in recent years, there has been increased competition among domestic and international participants in the online lottery industry. The online lottery business is highly competitive in the United States and internationally. Both in the United States and internationally, price is an increasingly important, but usually not the sole, criterion for selection. Other significant factors that influence the award of lottery contracts are: the ability to optimize lottery revenues through technical capability and applications knowledge; the quality, dependability and upgrade capability of the system; the marketing and gaming experience, financial condition and reputation of the vendor; and the satisfaction of other requirements and qualifications that the lottery authority may impose. During fiscal 2005, our principal competitors in the online lottery business (and the number of online lottery contracts serviced worldwide by such competitors) were as follows: Scientific Games Corporation (including the business formerly known as Automated Wagering International, Inc., and IGT Online Entertainment Systems, Inc.) (33); Essnet (22); and Intralot S.A. (20). PERSONNEL As of April 1, 2005, we had approximately 5,300 full-time employees worldwide. The vast majority of our domestic employees is not represented by any labor union. We believe that our relationship with our employees is satisfactory. ITEM 2. PROPERTIES Our world headquarters and research and development and main production facility are located in our approximately 260,000 square foot building on approximately 26 acres in West Greenwich, Rhode Island, which we lease from West Greenwich Technology Associates, L.P. Prior to February 1, 2005 we had a 50% limited partnership interest in this partnership. On February 1, 2005, we acquired the remaining 50% interest in, and presently own 100% of, West Greenwich Technology Associates, L.P. We also own approximately 24 acres adjoining our headquarters in West Greenwich, Rhode Island. In May 2003, we entered into a Master Contract with the Rhode Island Lottery that, among other matters, relates to the development of a new world headquarters facility containing at least 210,000 square feet in Providence, Rhode Island by December 31, 2006. See Note 8 to Notes to Consolidated Financial Statements for further information respecting the planned relocation of our World Headquarters to Providence, Rhode Island, and certain related matters. We also own an approximately 140,000 square foot manufacturing and central storage facility in Coventry, Rhode Island. Except in New York State, where we own our back-up data center facility, we lease, or are supplied by the relevant state authorities with, our data center facilities in the various jurisdictions. We also lease office, depot maintenance and warehouse space in a number of other locations. In addition, our subsidiary, Spielo Manufacturing, Inc., owns an approximately 113,000 square foot office building in Moncton, Canada, and leases an approximately 31,000 square foot manufacturing and warehouse facility in Saint-Anne-des-Monts, Canada. Our facilities are in good condition and are adequate for our present needs. ITEM 3. LEGAL PROCEEDINGS BRAZILIAN LEGAL PROCEEDINGS THE CEF CONTRACT PROCEEDINGS BACKGROUND. In January 1997, Caixa Economica Federal ("CEF"), the Brazilian bank and operator of Brazil's National Lottery, and Racimec Information Brasileira S.A. ("Racimec"), the predecessor of the Company's subsidiary GTECH Brasil Ltda. ("GTECH Brazil"), entered into a four-year contract pursuant to which GTECH Brazil agreed to provide online lottery services and technology to CEF (the "1997 Contract"). In May 2000, CEF and GTECH Brazil terminated the 1997 Contract and entered into a new agreement (the "2000 Contract") obliging GTECH Brazil to provide lottery goods and services and additional financial transaction services to CEF for a contract term that, as subsequently extended, was scheduled to expire in April 2003. In April 2003, GTECH Brazil entered into an agreement with CEF (the "2003 Contract Extension") pursuant to which: (a) the term of the 2000 Contract was extended into May 2005, and (b) fees payable to GTECH Brazil under the 2000 Contract were reduced by 15%. CEF recently completed a procurement process for products and services to replace those that we currently provide under the 2000 Contract. Based upon the commodity auction nature of the procurement process and the revenue restrictions that were then imposed on us by the courts, we elected not to participate in the bid process. CEF has also announced that it is developing its central system in-house. As provided in the 2000 Contract, CEF may elect to extend the 2000 Contract for one year beyond its scheduled May 2005 termination date on its existing terms and conditions. In addition we are currently involved in negotiations with CEF respecting the possible extension of the term of the 2000 Contract for the provision of goods and services by us after the scheduled termination date of the 2000 Contract. There can be no assurance that CEF will elect to extend the 2000 Contract for an additional year on its existing terms and conditions, or that CEF and GTECH Brazil will reach agreement to extend the term of the 2000 Contract on other terms. Revenues from the 2000 Contract accounted for approximately 7.2% of our total revenues for fiscal 2005, making CEF our second largest customer in fiscal 2005 based on revenues. CRIMINAL ALLEGATIONS AGAINST CERTAIN EMPLOYEES AND RELATED SEC INVESTIGATION. As previously reported, in late March 2004 federal attorneys with Brazil's Public Ministry (the "Public Ministry Attorneys") recommended that criminal charges be brought against nine individuals, including four senior officers of CEF, Antonio Carlos Rocha, the former Senior Vice President of Holdings and President of GTECH Brazil; and Marcelo Rovai, GTECH Brazil's marketing director. The Public Ministry Attorneys had recommended that Messrs. Rocha and Rovai be charged with offering an improper inducement in connection with the negotiation of the 2003 Contract Extension, and co-authoring, or aiding and abetting, certain allegedly fraudulent or inappropriate management practices of the CEF management who agreed to enter into the 2003 Contract Extension. No other present or former employee of the Company or GTECH Brazil has been implicated by the Public Ministry Attorneys. Neither the Company nor GTECH Brazil is the subject of this criminal investigation, and under Brazilian law (which provides that criminal charges may not be brought against corporations or other entities), we cannot be subject to criminal charges in connection with this matter. As previously reported, during the second quarter of fiscal 2005, the judge reviewing these charges prior to their being filed refused to initiate the criminal charges against the nine individuals, including against Messrs. Rocha and Rovai, but instead granted a request by the Brazilian Federal Police to continue the investigation which had been suspended upon the recommendation of the Public Ministry Attorneys that criminal charges be brought. The Brazilian Federal Police subsequently ended their investigation and presented a final report of their findings to the court. This final report does not recommend that indictments be issued against Messrs. Rocha or Rovai, or against any current or former employee of the Company. As previously reported, we cooperated fully with the investigation by Brazilian authorities respecting this matter, and encouraged Messrs. Rocha and Rovai to do the same. In addition, as previously reported, we conducted an internal investigation of the 2003 Contract Extension under the supervision of the independent directors of GTECH Holdings Corporation. Our investigation did not reveal any reason to believe that any of our present or former employees had committed any criminal offenses alleged by the Public Ministry Attorneys. Notwithstanding the favorable resolution of the Brazilian Federal Police investigation and the favorable results of our own internal investigation respecting the 2003 Contract Extension, there can be no assurance that (a) the Public Ministry Attorneys will not once again recommend to the judge hearing this case that such criminal charges be initiated against Messrs. Rocha and Rovai, (b) the Brazilian Federal Police will not broaden their investigation to include the award of, and performance under, the 1997 Contract and 2000 Contract, or (c) new criminal charges will not be initiated against Messrs. Rocha and Rovai or additional individuals. As previously reported, the United States Securities and Exchange Commission (the "SEC") is undertaking a formal investigation into the Brazilian criminal allegations against Messrs. Rocha and Rovai and the Company's involvement in this matter. The Company has been cooperating fully with the SEC. To date we have found no evidence that the Company, or any of its employees, has violated any United States law, or is otherwise guilty of any wrongdoing in connection with this matter. In light of the fact that our reputation for integrity is an important factor in our business dealings with lottery and other governmental agencies, an allegation or finding of improper conduct that is attributable to us could have a material adverse effect on our business, both within Brazil and elsewhere, including our ability to retain existing contracts or to obtain new or renewal contracts. See Item 1, "Certain Factors That May Affect Future Performance," above. CIVIL ACTION BY THE PUBLIC MINISTRY ATTORNEYS. As previously reported, in April 2004 the Public Ministry Attorneys initiated a civil action in the Federal Court of Brasilia against GTECH Brazil; 17 former officers and employees of CEF; the former president of Racimec; Antonio Carlos Rocha; and Marcos Andrade, another former officer of GTECH Brazil. The focus of this civil action is the contractual relationship between CEF, GTECH Brazil and Racimec during the period 1994 to 2002. This civil action alleges that the defendants acted illegally in entering into, amending and performing, the 1997 Contract, and the 2000 Contract, and seeks to invalidate the 2000 Contract, which, as extended by the 2003 Contract Extension, is still in force. As previously reported, this lawsuit also seeks to impose damages equal to the sum of all amounts paid to the Company under the 1997 Contract and the 2000 Contract, and certain other permitted amounts, minus our proven investment costs. The applicable statute also permits the assessment of penalties, in the discretion of the court, of up to three times the amount of the damages imposed. We estimate that through the date of the lawsuit we received under the 1997 Contract and the 2000 Contract a total of 1.5 billion Brazilian reals (or approximately 500 million United States dollars). In addition, although it is unclear how investment costs would be determined for purposes of this lawsuit, we estimate that our investment costs through the date of the lawsuit were approximately between 1.2 billion and 1.4 billion Brazilian reals (or approximately between 400 million and 465 million United States dollars) in aggregate; however, these investment costs could be disputed by CEF, and are ultimately subject to approval by the court. As previously reported, we believe we have good and adequate defenses to the claims made in this lawsuit. We intend to defend ourselves vigorously in these proceedings, which, we have been advised by our Brazilian counsel, are likely to take several years, and could take as long as 10 to 15 years in certain circumstances, to litigate through the appellate process to final judgment. It is our position that we were appropriately awarded the 1997 Contract by CEF after a competitive procurement, and that at all times since 1997 we have been appropriately compensated for services performed under valid contracts with the CEF. While we cannot rule out the possibility that the Company will ultimately be held liable in this matter, or estimate the amount of such liability in such event, we believe that the outcome of this lawsuit is not likely to have a material impact on our financial statements or business. As previously reported, in June 2004, the Federal Court of Brasilia granted a procedural injunction in connection with this civil matter which ordered that 30% of payments made subsequent to the date of the injunction to GTECH Brazil by CEF under the 2000 Contract be withheld and deposited into an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited into an account pursuant to this ruling was approximately 68 million Brazilian reals, or 26 million United States dollars. This injunction also put in place restrictions that effectively prevented the transfer or sale of the Company's Brazilian assets, including the share capital of GTECH Brazil, with certain limited exceptions. The injunction was granted as part of a confidential ex parte proceeding in which we were not afforded an opportunity to participate. We filed an appeal respecting the court's grant of this injunction in July 2004. On March 22, 2005, a panel of judges of the Brazilian Federal Court of Appeals heard our appeal of the procedural injunction granted by the Federal Court of Brasilia and issued an order: (a) discontinuing the withholding of payments due to GTECH Brazil from CEF that had been mandated by the procedural injunction, (b) removing the procedural injunction's restrictions on the transfer or sale of the Company's Brazilian assets, and (c) requiring the return to GTECH Brazil of amounts in excess of 40 million Brazilian reals held in escrow pursuant to the procedural injunction, thereby permitting the return to GTECH of approximately 11 million United States dollars of the 26 million United States dollars held in escrow as of the end of fiscal 2005. The appeals court also ordered that 40 million Brazilian reals continue to be held in escrow, and that the procedural injunction's requirements that defendants report assets to the court, and that the Brazilian Central Bank report any transaction associated with these assets, be maintained. This order of the Brazilian Federal Court of Appeals may be appealed by the Brazilian Public Attorneys. POPULAR CLAIM. As previously reported, in February 2004, Vincius Bijos, a Brazilian, commenced a public class action lawsuit in Brazil's Brasilia District Court of the Federal District against the Brazilian Federal government; CEF; several former and current officers of CEF; the former president of Racimec; and GTECH Brazil, seeking, among the relief requested of the Court, a preliminary injunction prohibiting CEF from making further payments to GTECH Brazil under the 2000 Contract, and an order that would terminate the 2000 Contract and require the defendants, jointly and severally, to refund amounts received by GTECH Brazil under the 1997 Contract and the 2000 Contract, together with interest, appropriate monetary adjustments, court costs and expenses. This public class action lawsuit bases its claims upon numerous alleged defects and irregularities, which the suit asserts violate Brazilian law, in the 1997 Contract and the 2000 Contract, and the manner in which the procurement processes that gave rise to the awards of these contracts were organized and administered. We intend to mount a vigorous challenge to the far-reaching claims that make up this lawsuit. We note that the Public Ministry Attorneys have filed an opinion with the federal court disagreeing with the request that an injunction enjoining payments from CEF to GTECH Brazil be entered and requesting that this suit be consolidated with the Public Ministry Attorneys' civil action described above. While we cannot rule out the possibility that the Company will ultimately be held liable in this matter, or estimate the amount of such liability in such event, we believe that the outcome of this lawsuit is not likely to have a material impact on our financial statements or business. TCU AUDIT. As previously reported, in June 2003, the Federal Court of Accounts ("TCU"), the court charged with auditing agencies of the Brazilian federal government and its subdivisions, summoned us, together with several current and former employees of the CEF to appear before TCU's Brasilia court. The summons required the defendants to show cause why they should not be required to jointly pay a base amount determined on a preliminary basis by the TCU to be due of R$91,974,625, duly indexed for inflation and interest as of May 26, 2000 (Decision No. 692/2003). We estimate that this claim, in aggregate, is for the local currency equivalent of approximately 87.6 million United States dollars at exchange rates in effect as of February 26, 2005. The allegations underlying this summons are set forth in a report (the "Audit Report") issued by the TCU in May 2003 respecting an audit conducted by the TCU of the 1997 Contract. The central allegation of the Audit Report is that under the 1997 Contract we were accorded certain payment increases, and we contracted to supply to CEF certain services, that were not contemplated by the procurement process respecting the 1997 Contract and that are not otherwise permitted under applicable Brazilian law. The Audit Report alleges that as a result of this, CEF overpaid us under the 1997 Contract for the period commencing in January 1997 through May 26, 2000, and that we are liable with respect to such alleged overpayments as specified above. The Audit Report states that the TCU will refer the Audit Report to, among others, the Public Ministry Attorneys and the Brazil Federal Police (who, we have been advised, are conducting an investigation of CEF's public procurement activities in general). See - "Criminal Allegations Against Certain Employees and Related SEC Investigation" and "Civil Action by Public Ministry Attorneys," above. The Audit Report does not allege that we have acted improperly. In November 2003, we presented our defense to the claims and preliminary determination of the TCU that CEF had overpaid us. In light of our defense, in September 2004, the TCU reduced its determination of the amount alleged to have been overpaid to us by CEF under the 1997 Contract from R$91,974,625 to R$30,317,721, or approximately 28.9 million United States dollars at exchange rates in effect as of February 26, 2005. This determination by the TCU remains subject to approval by TCU's judges. We plan to continue to vigorously defend ourselves against the allegations made by TCU in the Audit Report and the proceedings initiated by the TCU with respect thereto. We believe that we have good defenses to the claims and determinations of the TCU. We further believe that the claims and determinations of the Audit Report have, in essence, been merged into the civil action instituted by the Public Ministry Attorneys described above, and are accordingly unlikely to represent an independent potential source of liability for us. While we are unable to rule out the possibility that the Company will ultimately be held liable in this matter, we believe that the outcome of this matter is not likely to have a material impact on our financial statements or business. SERLOPAR SUIT As previously reported, in April 2002 Serlopar, the lottery authority for the Brazilian state of Parana, sued our subsidiaries Dreamport Brasil Ltda. and GTECH Brazil in the 2nd Public Finance Court of the City of Curitiba, State of Parana, under an agreement dated July 31, 1997, as amended (the "VLT Agreement"). Pursuant to the VLT Agreement, we agreed to install and operate video lottery terminals ("VLTs") in Parana. Serlopar alleges in its suit that we installed only 450 of the 1,000 VLTs that we were allegedly obliged to install, and that we were overpaid, and failed to reimburse Serlopar certain amounts alleged to be due to Serlopar, under the VLT Agreement. Serlopar seeks payment from us of approximately 40 million United States dollars (at exchange rates in effect on February 26, 2005) with respect to these claims, together with unspecified amounts alleged to be due from the defendants with respect to general losses and damages (including loss of revenues) and court costs and legal fees. We believe we have good defenses to the claims made by Serlopar in this lawsuit, and we intend to continue to defend ourselves vigorously in these proceedings. We believe that the outcome of this suit will not have a material impact on our financial statements or business. OTHER LEGAL PROCEEDINGS ARGENTINA MONEY TRANSFER MATTER In February 2005, GTECH Foreign Holdings Corporation, Argentina Branch ("GFHC") and our Argentina legal counsel, Dr. Jorge Perez of Perez, del Barba and Rosenblum, received notification from the Central Bank of Argentina that they were being indicted for alleged violations of Argentina's currency exchange laws. The Argentina laws in question prohibit the transfer of foreign currency from Argentina, subject to certain exceptions not here relevant. At issue is a February 2002 agreement (the "BofA Agreement") between GFHC and Bank of America, N.A., Buenos Aires Branch ("BofA") pursuant to which BofA assigned to GFHC a certificate of deposit in the amount of 571,429 United States dollars (the "CD"), issued by Bank of America, Charlotte, North Carolina Branch ("BofA-North Carolina"), in consideration for the payment of 1.4 million Argentina pesos. Upon maturity of the CD, the agreement provided for BofA-North Carolina to pay 571,429 United States dollars to a GFHC branch bank account in the United States. We understand that the central claim of the Argentina Central Bank's indictment will be that GFHC's agreement with BofA was a transaction in which foreign currency was transferred, in essence, from Argentina to the United States in violation of applicable Argentina law. If GFHC is found guilty of violating applicable Argentina currency exchange laws, as charged in the indictment, we would be liable to pay a fine of up to approximately 5.7 million United States dollars (i.e., ten times the amount of United States dollars allegedly transferred from Argentina) and could be prohibited for up to ten years from importing goods into, or exporting goods from, Argentina. We note that BofA, which solicited GTECH to enter into the BofA Agreement, and approximately 20 other customers of BofA including several subsidiaries of large multi-national corporations, have been indicted in connection with transactions similar to the transaction outlined in the BofA Agreement. BofA explicitly represented to us in the BofA Agreement that the transaction described therein did not violate any Argentina law or regulation, and we believe that we took appropriate measures independent of this representation (including obtaining the opinion of local counsel) in advance of entering into the BofA Agreement to ascertain that this transaction was legal under applicable Argentina law. We believe that we have good defenses to the claims made on the indictment, and we intend to vigorously defend ourselves in these proceedings. We do not believe that the outcome of this suit will have a material impact on our financial statements or business. COHEN SUIT As previously reported, on August 7, 2002 we terminated without cause the employment of Howard S. Cohen, our former President and Chief Executive Officer. In March 2003, Mr. Cohen attempted to exercise options granted by us in April 2002 to purchase (on a pre-split adjusted basis) 450,000 shares of our Common Stock at a per-share exercise price of $23.30. The non-qualified stock option agreement entered into between Mr. Cohen and us respecting the April 2002 grant of options provides by its terms that, in the event that Mr. Cohen's employment was terminated without cause, options remaining exercisable must be exercised within six months from the date of termination (i.e., by February 7, 2003). Because Mr. Cohen had failed to exercise his April 2002 options within the term provided in the applicable stock option agreement, we did not permit Mr. Cohen to exercise these options. In May 2003, Mr. Cohen filed suit in Rhode Island Superior Court against us and the attorneys who had advised him in connection with the negotiation of his severance agreement, respecting his attempt to exercise the April 2002 stock options. The suit, captioned Howard S. Cohen v. GTECH Corporation, GTECH Holdings Corporation, Michael J. Tuchman, Levenfeld Pearlstein, Charlene F. Marant and Marant Enterprises Holdings LLC, alleges that: (i) we breached our agreements with Mr. Cohen in failing to allow him to exercise his April 2002 options; (ii) through fraud by us, or the mutual mistake of the parties, the April 2002 option grant does not reflect the intent of the parties, and (iii) we had a duty to advise Mr. Cohen of his mistaken belief (if such it was) as to the exercise term of the April 2002 options, and failed to so advise Mr. Cohen. Mr. Cohen also alleges that his attorneys had failed in their duty of care in misadvising him as to the correct period during which he could exercise his options, and, in addition, had practiced law in Rhode Island without a license in violation of applicable Rhode Island law. Mr. Cohen seeks damages against us and the other defendants in an amount of not less than 4.0 million United States dollars, plus interest, costs and reasonable attorneys fees. With respect to us, he also seeks an order reforming the terms of the April 2002 option grant to reflect the alleged intent of the parties with respect to the post-termination exercise term, and other equitable relief. Mr. Cohen also asks for a declaratory judgment construing our 2000 Omnibus Stock Option and Long Term Incentive Plan and Mr. Cohen's employment and severance agreements, as to the relevant option exercise period. We believe that we have good defenses to the claims made by Mr. Cohen in this lawsuit and we intend to vigorously defend ourselves in these proceedings. Nevertheless, at the present time we are unable to predict the outcome of this lawsuit. For further information respecting legal proceedings, see Item 1, "Certain Factors Affecting Future Performance" and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of this report, and Item 8, Note 14 to Notes to Consolidated Financial Statements included in this report. We also are subject to certain other legal proceedings and claims which management believes, on the basis of information presently available to it, will not materially adversely affect our consolidated financial position or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of GTECH Holdings Corporation ("Holdings") during the last quarter of fiscal 2005. ADDITIONAL INFORMATION The following information is furnished in this Part I pursuant to Instruction 3 to Item 401(b) of Regulation S-K: EXECUTIVE OFFICERS The Executive Officers of Holdings as of April 1, 2005 were:
Name Age Position ------------------ --- ---------------------------------------- W. Bruce Turner 45 President and Chief Executive Officer since August 2002. Mr. Turner, who is also a Director of Holdings, was elected the Chairman of Holdings by the Board in July 2000, and subsequently served as Holdings' acting Chief Executive Officer from August 2000 through March 2001. Previously, Mr. Turner was an independent consultant and private investor from February 1999 to July 2000. Mr. Turner was a Managing Director, Equity Research, for Salomon Smith Barney (formerly Salomon Brothers) from January 1994 until February 1999; and Director, Leisure Equity Research for Raymond James & Associates from October 1989 until January 1994. Marc A. Crisafulli 36 Senior Vice President, Gaming Solutions since December 2003; Senior Vice President, General Counsel and Secretary since March 2001 and Chief Compliance Officer since September 2001. Previously, Mr. Crisafulli was an associate (from September 1994 through June 2000) and a partner (from July 2000 through March 2001) of the Providence-based law firm of Edwards & Angell, LLP where he practiced as a commercial trial lawyer. Walter G. DeSocio 50 Senior Vice President, General Counsel and Secretary since January 2005. Previously, Mr. DeSocio served from September 2002 to December 2004 as Chief Administrative Officer, General Counsel, and Corporate Secretary at Internap Network Services Corporation, the leading provider of intelligent routing services over the Internet. Prior to joining Internap, Mr. DeSocio served from June 1999 to September 2002 as General Counsel and Senior Vice President of Regulatory Affairs at Concert B.V., the multi-billion dollar global communications business owned by AT&T and BT Group, and from June 1996 to June 1999, as AT&T's Chief Regional Counsel for Europe, Middle East, and Africa. Timothy B. Nyman 54 Senior Vice President of Global Services since October 2002. Previously, beginning in 1981, Mr. Nyman was employed by the
Name Age Position ------------------ --- ---------------------------------------- Company in a series of increasingly responsible positions including, through September 2002, as the Company's Vice President of Client Services. Jaymin B. Patel 37 Senior Vice President and Chief Financial Officer since January 2000. Previously, beginning in 1994, Mr. Patel was employed by the Company in a series of increasingly responsible positions including, from April 1998 until January 2000, as GTECH's Vice President, Financial Planning and Business Evaluation. Prior to his arrival at the Company, Mr. Patel served as a Chartered Accountant with PriceWaterhouse in London. Donald R. Sweitzer 57 Senior Vice President, Global Business Development & Public Affairs, since February 2003. Mr. Sweitzer joined the Company in July 1998 as its Senior Vice President, Government Relations, and later served as the Company's Senior Vice President, Public Affairs, through January 2003. Previously, Mr. Sweitzer was President of the Dorset Resource and Strategy Group, a government affairs consultancy, from November 1996 through June 1998, and President and Managing Partner of Politics Inc., a political consulting firm, from January 1995 through August 1996. Mr. Sweitzer also served as the Political Director of the Democratic National Committee from April 1993 through January 1995, and served as the Finance Director of this same body from April 1985 through January 1989. Barbara Burns 55 Senior Vice President of Human Resources from December 2004 until her resignation in April 2005. Ms. Burns had previously been employed by the Company since December 2000 as a Vice President of Human Resources. Prior to this, Ms. Burns served as a Vice President of Human Resources at Siemens, A.G., one of the world's leading electrical engineering and electronics companies (from 1999 to 2000); and Ryder System, Inc., a leading provider of transportation, logistics and supply chain management (during 1999). Previously Ms. Burns had been employed in a human resources capacity by computer companies Compaq Computer Corporation and Digital Equipment Corporation (from 1979 until 1998). In April 2005, Ms. Burns resigned from the Company effective April 22, 2005. David J. Calabro 55 Executive Vice President and Chief Operating Officer from October 2002 Executive Vice through May 15, 2005, the announced date of his retirement. Mr. Calabro previously served as the Company's President, Global Operations, from October 2001, and Senior Vice President with responsibility for the Company's worldwide facilities management business, from March 1999. Prior to this Previously, Mr. Calabro was employed by Unisys Corporation, a leading provider of information technology, from May 1995 through February 1999 as its Vice President and General Manager of the United States and Canada Public Sector Market Group, and prior to that, was Director of Business Operations
Name Age Position ------------------ --- ---------------------------------------- (Government Systems Group) from August 1987 through April 1995 for Digital Equipment Corporation, a leading supplier of computer goods and services. On April 6, 2005, Holdings announced that Mr. Calabro had elected to retire from the Company with effect from May 15, 2005.
Executive officers and other officers are elected or appointed by, and serve at the pleasure of, the Board of Directors. Some are party to employment contracts with the Company. The information set forth above reflects positions held with Holdings except as expressly provided to the contrary. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The principal United States market on which Holdings' Common Stock is traded is the New York Stock Exchange where it is traded under the symbol "GTK." The following table sets forth on a per share basis the high and low sale prices of Common Stock for the fiscal quarters indicated, as reported on the New York Stock Exchange Composite Tape. All share prices set forth below reflect the 2-for-1 stock split of the Common Stock effected in the form of a stock dividend distributed during the second quarter of fiscal 2005.
FISCAL 2005 HIGH LOW ------------------------------------------------------ ------ ------ First Quarter (February 29 - May 29, 2004) $31.49 $24.34 Second Quarter (May 30 - August 28, 2004) $27.57 $19.65 Third Quarter (August 29 - November 27, 2004) $25.32 $22.26 Fourth Quarter (November 28, 2004 - February 26, 2005) $28.42 $23.01
FISCAL 2004 HIGH LOW ------------------------------------------------------ ------ ------ First Quarter (February 23 - May 24, 2003) $18.48 $13.40 Second Quarter (May 25 - August 24, 2003) $20.95 $16.65 Third Quarter (August 24 - November 22, 2003) $24.55 $20.03 Fourth Quarter (November 23, 2003 - February 28, 2004) $30.12 $23.71
The closing price of the Common Stock on the New York Stock Exchange on April 15, 2005 was $23.77. As of April 15, 2005, there were approximately 745 holders of record of the Common Stock. Prior to July 2003, Holdings had never paid cash dividends on its Common Stock. Commencing in July 2003 with respect to the second quarter of fiscal 2004, Holdings has paid a quarterly cash dividend to its shareholders in the amount (adjusted for the fiscal 2005 stock split) of $0.085 per share. Due to the fact that Holdings is a holding company, and its operations are conducted through the Company, the ability of Holdings to pay dividends on its Common Stock in the future will be dependent on the earnings and cash flow of its subsidiaries, and the availability of such cash flow to Holdings. The following table presents information regarding purchases by Holdings of shares of its Common Stock, par value $.01 per share (the "Shares") made during the three months ended February 26, 2005.
(d) Approximate Dollar Value of (a) Total Number (b) Average (c) Total Number of Shares Shares that May Yet of Shares Price Paid Purchased as Part of Publicly Be Purchased Under Period Purchased per Share Announced Plans or Programs the Plans or Programs ------------------ ---------------- ----------- ----------------------------- --------------------- November 28, 9,000 $23.63 9,000 $99,250,865 2004 to January 1 , 2005 January 2, 2005 to 406,500 $23.48 406,500 $89,708,072 January 29, 2005 January 30, 2005 437,900 $23.67 437,900 $79,342,319 to February 26, 2005 ------- ------- Total 853,400 853,400 ------- -------
On November 2, 2004, we publicly announced that our Board of Directors authorized a program for Holdings to purchase up to an aggregate of $100 million of its outstanding Common Stock through February 25, 2006, pursuant to which these Shares were purchased. The remainder of the response to this Item incorporates by reference Item 8, Note 18 to Notes to Consolidated Financial Statements. All securities reflected in Note 18 are authorized for insurance under compensation plans previously approved by Holdings' shareholders. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data below should be read in conjunction with Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations," the consolidated financial statements and the other financial information included in this report. With the exception of the number of lottery customers at year end, the data in the table is derived from our audited consolidated financial statements.
Fiscal Year Ended ------------------------------------------------------------------------- February 26, February 28, February 22, February 23, February 24, 2005 2004 (a) 2003 2002 2001 ------------ ------------- ------------ ------------ ------------ (Dollars in thousands, except per share amounts) OPERATING DATA: Revenues: Services $ 1,017,683 $ 957,471 $ 868,896 $ 831,787 $ 856,475 Sales of products 239,552 93,859 109,894 177,914 80,068 ------------ ------------- ------------ ------------ ------------ Total 1,257,235 1,051,330 978,790 1,009,701 936,543 Gross Profit: Services 401,050 419,632 333,855 245,479 292,380 Sales of products 81,578 34,633 30,951 41,462 5,224 ------------ ------------- ------------ ------------ ------------ Total 482,628 454,265 364,806 286,941 297,604 Special charges (credit) (b) -- -- (1,121) -- 42,270 Operating income 312,816 287,855 226,945 134,350 81,905 Net income 196,394 183,200 142,021 68,026 43,148 PER SHARE DATA: (C) Basic $ 1.68 $ 1.57 $ 1.24 $ 0.58 $ 0.31 Diluted (d) 1.50 1.40 1.11 0.51 0.31 CASH DIVIDENDS DECLARED PER COMMON SHARE $ 0.34 $ 0.255 $ -- $ -- $ -- DIVIDENDS PAID $ 39,830 $ 29,977 $ -- $ -- $ -- BALANCE SHEET DATA (AT END OF PERIOD): Cash and cash equivalents $ 94,446 $ 129,339 $ 116,174 $ 35,095 $ 46,948 Investment securities available-for-sale 196,825 221,850 -- -- -- Total assets 1,855,141 1,559,131 954,195 853,829 938,160 Long-term debt, less current portion 726,329 463,215 287,088 329,715 316,961 Shareholders' equity 655,768 562,289 315,566 202,955 314,362 CASH FLOW DATA: Net cash provided by operating activities $ 375,209 $ 415,067 $ 332,256 $ 345,230 $ 251,970 Net cash used for investing activities (429,582) (612,459) (158,608) (164,726) (162,566) Net purchases (maturities) of available-for-sale investment securities (25,025) 221,850 -- -- -- ------------ ------------- ------------ ------------ ------------ Free cash flow (e) $ (79,398) $ 24,458 $ 173,648 $ 180,504 $ 89,404 ============ ============= ============ ============ ============ Net cash provided by (used for) financing activities $ 17,505 $ 206,206 $ (96,193) $ (188,341) $ (50,725) OTHER DATA: Income before income taxes $ 306,386 $ 290,794 $ 229,066 $ 109,720 $ 70,735 Interest expense 19,213 10,919 11,267 22,876 27,165 Depreciation and amortization 158,615 119,059 138,185 168,543 174,395 ------------ ------------- ------------ ------------ ------------ EBITDA (f) $ 484,214 $ 420,772 $ 378,518 $ 301,139 $ 272,295 ============ ============= ============ ============ ============ Number of lottery customers at year-end (g) 92 84 84 82 83
---------- (a) 53-week year. (b) The impact of the special charges (credit) on earnings per share on a diluted basis was ($0.01) and $0.19 in fiscal 2003 and 2001, respectively. (c) Per share data has been restated to reflect our 2-for-1 common stock split that occurred in July 2004. (d) We adopted EITF 04-8 in December 2004, which requires that all 12.7 million shares underlying our 1.75% Convertible Debentures be included in diluted earnings per share computations, if dilutive, regardless of whether the conversion requirements have been met. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02, $0.10 and $0.06 in fiscal 2004, 2003 and 2002, respectively. (e) Free cash flow (net cash provided by operating activities less net cash used for investing activities, excluding the net purchases or maturities of available-for-sale investment securities), represents the excess cash flows generated over and above the investment of capital required to both maintain and grow our ongoing revenue streams. Based upon the long term contractual cycles in our business, we believe free cash flow trends represent a useful guide to help determine the amount of internally generated capital available for enhancing long-term shareholder value, through a balance of investing in new growth opportunities, the tax efficient return of capital to our shareholders and repayment of debt obligations. As we define it, free cash flow may not be comparable to other similarly titled measures used by other companies. (f) We believe that earnings before interest, taxes, depreciation and amortization, or EBITDA, assists in explaining trends in our operating performance, provides useful information about our ability to incur and service indebtedness and is a commonly used measure of performance by securities analysts and investors in the gaming industry. EBITDA should not be considered as an alternative to operating income as an indicator of our performance or to cash flows as a measure of our liquidity. As we define it, EBITDA may not be comparable to other similarly titled measures used by other companies. (g) A lottery customer is defined as a jurisdiction utilizing our systems or products for a traditional online lottery. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The following Management's Discussion and Analysis ("MD&A") is intended to help the reader understand the financial results of GTECH Holdings Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes. This overview provides guidance on the individual sections of MD&A as follows: - FORWARD-LOOKING STATEMENTS - cautionary information about forward-looking statements. - OUR BUSINESS - a general description of our business; Brazil matters; acquisitions; our common stock split and treasury stock retirement; and new accounting pronouncements. - APPLICATION OF CRITICAL ACCOUNTING POLICIES - a discussion of accounting policies that we believe are both most critical to our financial condition and results of operations, and require management's most difficult, subjective or complex judgments and estimates. - OPERATIONS REVIEW - an analysis of our consolidated results of operations for the three years presented in our financial statements. We operate in one business - Transaction Processing, and we have a single operating and reportable business segment. Therefore, our discussions are not quantified by segment results. - LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION - an analysis of cash flows, financial position, contractual obligations and commitments. - FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY - information about financial risk management; interest rate market risk; equity price risk; foreign currency exchange rate risk; and our dividend policy. - SUBSEQUENT EVENTS - information about material events that occurred subsequent to February 26, 2005. Unless specified otherwise, we use the terms "Holdings," "the Company," "we," "our," and "us" in MD&A to refer to GTECH Holdings Corporation and its consolidated subsidiaries included in the consolidated financial statements. FORWARD-LOOKING STATEMENTS Statements contained in this section and elsewhere in this report which are not historical statements constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934. Generally, the words "believe," "expect," "estimate," "anticipate," "will," "may," "could," "plan," "continue" and similar expressions identify forward-looking statements. See Item 1 - "Forward-Looking Statements" and "Certain Factors That May Affect Future Performance" for further information. OUR BUSINESS GENERAL We operate on a 52-week or 53-week fiscal year ending on the last Saturday in February. Fiscal 2005 and 2003 were 52-week years. Fiscal 2004 was a 53-week year and we included the extra week in our fourth quarter ended February 28, 2004. We are a global gaming and technology company providing software, networks and professional services that power high-performance, transaction processing systems. We are the world's leading operator of highly-secure online lottery transaction processing systems, doing business in 54 countries worldwide and we have a growing presence in commercial gaming technology ("Gaming solutions") and financial services transaction processing ("Commercial services"). A comparison of our revenue concentration is as follows:
Fiscal Fiscal Fiscal Consolidated Revenues 2005 2004 2003 --------------------- ------ ------ ------ Lottery 87% 91% 93% Commercial services 7% 7% 5% Gaming solutions 6% 2% 2% ------ ------ ------ 100% 100% 100% ====== ====== ======
Being a global business, we derive a substantial portion of our revenue from our operations outside of the United States. In particular, in fiscal 2005, we derived 52.2% of our revenues from international operations, including 7.4% of our revenues from our Brazilian operations alone (including 7.2% of our revenues from Caixa Economica Federal, the operator of Brazil's National Lottery, our second largest customer in fiscal 2005 based on annual revenues). In addition, substantial portions of our assets, primarily consisting of equipment we use to operate online lottery systems for our customers, are held outside of the United States. We are also exposed to more general risks of international operations, including increased governmental regulation of the online lottery industry in the markets where we operate; exchange controls or other currency restrictions; and significant political instability. We have derived substantially all of our revenues from the rendering of services and the sale or supply of computerized online lottery systems and components to government-authorized lotteries. Our service revenues are derived primarily from lottery service contracts, which are typically at least five to seven years in duration, and generally provide compensation to us based upon a percentage of a lottery's gross online and instant ticket sales. These percentages vary depending on the size of the lottery and the scope of services provided to the lottery. We primarily derive product sale revenues from the installation of new online lottery systems, installation of new software and sales of lottery terminals and equipment in connection with the expansion of existing lottery systems. Our product margins fluctuate depending on the mix, volume and timing of product sale contracts. Our product sale revenues from period to period may not be comparable due to the size and timing of product sale transactions. During fiscal 2006, we currently anticipate that product sales will be in the range of $180 million to $210 million. Our compensation under lottery service contracts is typically based upon a percentage of a lottery's gross online and instant ticket sales. Over the past several fiscal years, we have experienced and may continue to experience a reduction in the percentage of lottery ticket sales we receive from certain customers resulting from contract rebids, extensions and renewals due to a number of factors, including the substantial growth of lottery sales over the last decade, reductions in the cost of technology and telecommunications services, and general market and competitive dynamics. In anticipation and response to these trends, beginning in fiscal 2001, we began the implementation of our new Enterprise Series-led technology strategy combined with the implementation of a number of ongoing cost savings initiatives and efficiency improvement programs designed to enable us to maintain our market leadership in the lottery industry. We are unable to determine at this time the likely effect of this trend on our business. Our business is highly regulated, and the competition to secure new government contracts is often intense. In addition, our ability to consummate the acquisition, which we announced in December 2004, of a 50 percent controlling equity interest in the Atronic group of companies, one of the world's five largest manufacturers of slot machines, and to otherwise expand our business in non-lottery gaming markets, is contingent upon obtaining required gaming licenses. 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 government authorities into possible improprieties and wrongdoing in connection with efforts to obtain and/or the awarding of lottery contracts and related matters. Because 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, gaming licensing, 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, obtain new or renewal contracts and to expand our business in non-lottery gaming markets. 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: - Part I, Item 1 - "Certain Factors That May Affect Future Performance - Government regulations and other actions affecting the online lottery industry could have a negative effect on our business and sales;" - Part I, Item 3 - "Legal Proceedings;" - Note 14 to the consolidated financial statements. BRAZIL MATTERS Revenues from our lottery contract with Caixa Economica Federal ("CEF"), our customer and the operator of Brazil's National Lottery, accounted for 7.2% of our total fiscal 2005 revenues, making CEF our second largest customer in fiscal 2005 based upon annual revenues. A June 25, 2004 ruling (the "Ruling") in a civil action initiated by federal attorneys with Brazil's Public Ministry had the effect in fiscal 2005 of materially reducing payments that we otherwise would have received from our lottery contract with CEF which expires in May 2005. The Ruling ordered that 30% of payments subsequent to the Ruling due to GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited in an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited in an account maintained by the Court was approximately 68 million Brazilian reals, or $26 million. In fiscal 2005, we did not recognize service revenues for the payments that were withheld from GTECH Brazil, as realization of these amounts was not reasonably assured. In July 2004 we filed an appeal of the Ruling and in March 2005 (after the close of fiscal 2005), an appellate court decision ordered that the withholding be discontinued and that all funds currently held in escrow in excess of 40 million Brazilian reals be returned to us, which amounts to $11 million of the $26 million withheld as of February 26, 2005. We received and recognized these funds as service revenue on April 13, 2005. In addition, the Ruling ordered that all assets of GTECH Brazil be identified to the Court so as to prevent their transfer or disposition, a requirement that was also subsequently reversed by the appellate court decision in March 2005. As of February 26, 2005, GTECH Brazil assets approximated $34.9 million as follows (dollars in millions): Cash $ 5.1 Systems, Equipment and Other Assets Relating to Contracts, net 5.7 ----- Assets restricted from transfer or disposition $10.8 All other assets 24.1 ----- GTECH Brazil assets at February 26, 2005 $34.9 =====
The restricted cash of $5.1 million is included in Other Assets in our Consolidated Balance Sheet. We are currently involved in negotiations with CEF respecting the possible extension of the term of our current contract, which expires in May 2005, for the provision of goods and services by us after the scheduled termination date of our current contract. Foreign currency translation related to our operations in Brazil of $59.5 million (which is recorded in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheet at February 26, 2005), would be recorded as a charge to our consolidated income statement upon the expiration of our contract with CEF should we determine that the expiration of the CEF contract results in a substantial liquidation of our investment in Brazil. Refer to Part I, Item 3, "Legal Proceedings - Brazilian Legal Proceedings, The CEF Contract Proceedings," and Note 14 to the consolidated financial statements for detailed disclosures regarding this matter. ACQUISITIONS BILLBIRD S.A. During the third quarter of fiscal 2005, our majority-owned subsidiary, PolCard S.A. ("PolCard"), acquired privately-held BillBird S.A ("BillBird"), the leading provider of electronic bill payment services in Poland, for an all-cash purchase price of approximately $6.0 million. By combining BillBird and PolCard (which is the leading debit and credit card merchant transaction acquirer and processor company in Poland), we will enhance our market strategy of providing a product suite including debit and credit transaction processing, card and ATM management services, electronic bill payments, and prepaid mobile phone top-ups. LEEWARD ISLANDS LOTTERY HOLDING COMPANY INC. During the first quarter of fiscal 2005, we acquired privately-held Leeward Islands Lottery Holding Company Inc. ("LILHCo"), a lottery operating company headquartered on the Caribbean islands of Antigua and St. Croix, for an all-cash purchase price of approximately $40 million. By acquiring Caribbean-based LILHCo, we will enhance our strategic foothold in that region, as well as provide significant growth opportunities in additional jurisdictions throughout the Caribbean. SPIELO MANUFACTURING INCORPORATED During the first quarter of fiscal 2005, we acquired privately-held Spielo Manufacturing Incorporated ("Spielo"), a leading provider of video lottery terminals ("VLT's") and related products and services to the global gaming industry, for an all-cash purchase price of approximately $150 million. In addition, we paid Spielo shareholders approximately $10.7 million out of a potential maximum earn-out amount of up to $35 million, which Spielo shareholders are entitled to receive in the 18 months following the closing, based upon Spielo achieving certain VLT installation objectives in New York and separately, a working capital adjustment of approximately $1.5 million. By acquiring Spielo, we will be better able to deliver a comprehensive, integrated VLT solution to our existing and potential customers, with a single point of contact and accountability. We currently do not expect to pay any significant amounts remaining under the earn-out provision. We continue to evaluate a variety of opportunities to broaden our offerings of high-volume transaction processing services outside of our core market of providing online lottery services, such as the processing and transmission of commercial, non-lottery transactions including bill payments, electronic tax payments, utility payments, prepaid cellular telephone recharges and retail-based programs such as gift cards. Currently, our networks in Brazil, Poland, Chile, the Czech Republic and Jamaica process bill payments and other commercial service transactions. In the near term, we expect to concentrate our efforts to grow commercial service revenues principally in Central and Eastern Europe and other selected emerging economies. While our goal is to leverage our technology, infrastructure and relationships to drive growth in commercial services, if, in the course of pursuing these opportunities, we identify an opportunity to gain access to certain markets through the acquisition of existing businesses, we may consider making such acquisitions. COMMON STOCK SPLIT AND TREASURY STOCK RETIREMENT On June 17, 2004, our Board of Directors approved a 2-for-1 common stock split, payable in the form of a stock dividend, which entitled each shareholder of record on July 1, 2004 to receive one share of common stock for each outstanding share of common stock held on that date. The stock dividend was distributed on July 30, 2004. All references to common shares and per share amounts herein have been restated to reflect the stock split for all periods presented. In connection with the declaration of the stock dividend, our Board of Directors approved the retirement of 69.8 million shares of our common stock held in treasury on July 29, 2004 (stated on a basis reflecting the stock split which occurred subsequent to the retirement). The $528.8 million of treasury stock at the time of the retirement was eliminated from treasury stock through a charge to retained earnings and common stock. NEW ACCOUNTING PRONOUNCEMENTS FASB STATEMENT NO. 123R In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which is a revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation". SFAS 123R supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and amends FASB Statement No. 95, "Statement of Cash Flows". SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than the beginning of the first fiscal year beginning after June 15, 2005 (our fiscal 2007 first quarter). Early adoption is permitted. We plan to adopt SFAS 123R on the first day of fiscal 2007 (February 26, 2006). SFAS 123R permits public companies to adopt its requirements using either the modified prospective transition ("MPT") method or the modified retrospective transition ("MRT") method. Under the MPT method, compensation cost for new awards and modified awards are recognized beginning with the effective date and the cost for awards that were granted prior to, but not vested as of the effective date, will be based on the grant date fair value estimate used for SFAS 123 pro forma disclosure purposes. The MRT method includes the requirements of the MPT method but also permits restatement of all prior periods presented or only the prior interim periods of the year of adoption. We plan to adopt SFAS 123R using the MPT method and we intend to use a lattice model to value stock options granted after February 26, 2006. We currently account for share-based payments to employees using the intrinsic value method under APB 25 and related Interpretations, and as such, we generally recognize no compensation cost for employee stock options. We currently estimate the impact of adopting SFAS 123R will be in a range of $0.04 to $0.06 per diluted share in fiscal 2007. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for these excess tax deductions were $11.3 million, $10.4 million and $8.0 million in fiscal 2005, 2004 and 2003, respectively. FASB STAFF POSITION NO. 109-1 In December 2004, the FASB issued FASB Staff Position No. 109-1, "Application of FASB Statement No. 109, `Accounting for Income Taxes', to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004" ("FSP 109-1"). FSP 109-1 provides guidance on the application of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), to the provision of the American Jobs Creation Act of 2004 (the "Act") that provides a tax deduction on qualified production activities. The FASB staff believes that the deduction should be accounted for as a special deduction in accordance with SFAS 109 as opposed to a tax rate reduction. FSP 109-1 is effective immediately. Pursuant to the Act, we will be able to benefit from a tax deduction for qualified production activities in fiscal 2006. We will follow the provisions of this guidance when applicable. We have not yet determined the impact this tax deduction will have on our results of operations or financial position. FASB STAFF POSITION NO. 109-2 In December 2004, the FASB issued FASB Staff Position No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP 109-2"). FSP 109-2 provides for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision). FSP 109-2 provides accounting and disclosure guidance for the repatriation provision and is effective immediately. While we continue to evaluate the Act, we do not plan to elect the one-time provision because of the resulting loss of foreign tax credits and because the vast majority of our permanently reinvested non-U.S. earnings have been deployed in active non-U.S. business operations. EITF 04-8 In October 2004, the FASB ratified the Emerging Issues Task Force's consensus on Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-8"), which is effective for periods ending after December 15, 2004. Under current interpretations of FAS 128, "Earnings per Share", issuers of contingently convertible debt instruments exclude the potential common shares underlying the debt instrument from the calculation of diluted earnings per share until the contingency is met. EITF 04-8 requires that potential shares underlying the debt instrument be included in diluted earnings per share computations, if dilutive, regardless of whether the contingency has been met. We adopted EITF 04-8 in December 2004 and retroactively adjusted all prior period diluted earnings per share amounts to conform to the guidance in EITF 04-8. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02 and $0.10 in fiscal 2004 and 2003, respectively. APPLICATION OF CRITICAL ACCOUNTING POLICIES We have identified the accounting policies listed below that we believe are both most critical to our financial condition and results of operations, and require management's most difficult, subjective or complex judgments in estimating the effect of inherent uncertainties. This section should be read in conjunction with Note 1 to the consolidated financial statements, which includes other significant accounting policies. REVENUE RECOGNITION LOTTERY AND GAMING TRANSACTION PROCESSING SERVICES We generally conduct our lottery and gaming business under two types of contractual arrangements: Facilities Management Contracts and Product Sales Contracts. FACILITIES MANAGEMENT CONTRACTS A majority of our revenues are derived from facilities management contracts, under which we construct, install, operate and retain ownership of the online lottery system ("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 ticket sales or a percentage of net machine income. These fees are recognized as revenue in the period earned and are classified as Service Revenue in our Consolidated Income Statements when all of the following criteria are met: - Persuasive evidence of an arrangement exists, which is typically when a customer contract has been signed - Services have been rendered - Our fee is deemed to be fixed or determinable and free of contingencies or significant uncertainties - Collectibility is reasonably assured In instances where customer acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met. PRODUCT SALES CONTRACTS Under product sales contracts, we construct, sell, deliver and install a turnkey lottery system or deliver lottery equipment, and license the computer software for a fixed price, and the lottery authority subsequently operates the lottery system. Product sale contracts generally include customer acceptance provisions and general customer rights to terminate the contract if we are in breach of the contract. Because product sales contracts include significant customization, 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 classified as Sales of Products in our Consolidated Income Statements and is recognized upon customer acceptance as long as there are no substantial doubts regarding collectibility. Whenever we enter into a product sale contract that involves the delivery or performance of multiple products and services that include the development and customization of software, implementation services, and licensed software and support services, we apply the consensus of EITF 00-21 "Revenue Arrangements with Multiple Deliverables", to determine whether the non-customization related deliverables specified in the contract should be treated as separate units of accounting for revenue recognition purposes. If the elements qualify as separate units of accounting, and fair value exists for the elements of the contract that are unrelated to the customization services, these elements are accounted for separately, and the related revenue is recognized as the products are delivered or the services are rendered. The application of revenue recognition principles requires judgment, including whether our product sales contracts include multiple elements, and if so, whether fair value exists for those elements. As a result, contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, the relative fair value that should be allocated to each of the elements and when to recognize revenue for each element. Our interpretation would not affect the amount of revenue recognized but could impact the timing of revenue recognition. Revenues attributable to any ongoing services provided subsequent to customer acceptance are classified as Service Revenue in our Consolidated Income Statements in the period earned. In certain product sale contracts (primarily the stand alone sale of lottery or video lottery terminals and software deliverables that do not involve significant customization of software), we are not responsible for installation. In these cases, we recognize revenue when all of the following criteria are met: - Persuasive evidence of an arrangement exists, which is typically when a customer contract has been signed - The product has been delivered - Our fee is deemed to be fixed or determinable and free of contingencies or significant uncertainties - Collectibility is reasonably assured In instances where installation and/or customer acceptance of the product is required, revenue is deferred until installation is complete and any acceptance criteria have been met. Our typical payment terms under product sale contracts include customer progress payments based on specific contract milestones with final payment due on or shortly after customer acceptance. We do not generally offer our customers payment terms that extend substantially beyond customer acceptance. In the rare case that we provide a customer with extended payment terms, we defer revenue equal to the amount of the extended payment until it is received. NON-LOTTERY TRANSACTION PROCESSING SERVICES We offer high-volume transaction processing services outside of our core market of providing online lottery services that consist of the acquiring, processing and transmission of commercial non-lottery transactions. Such transactions include retail debit, credit and charge card transactions, bill payments, electronic tax payments, utility payments, prepaid cellular telephone recharges and retail-based programs. We earn a fee for processing commercial non-lottery transactions that is transaction-based (a fixed fee per transaction or a fee based on a percentage of dollar volume processed). We recognize these fees as service revenue at the time a transaction is processed based on the net amount retained in accordance with Emerging Issues Task Force Issue No. 99-19, "Reporting Revenue Gross as a Principal Versus Net as an Agent." DEFERRED REVENUE AND LIQUIDATED DAMAGE ASSESSMENTS Amounts received from customers in advance of revenue recognition are recorded in Advance Payments from Customers in our Consolidated Balance Sheets. We record liquidated damage assessments, which are penalties incurred due to a failure to meet specified deadlines or performance standards, as a reduction of revenue in the period they become probable and estimable. Liquidated damage assessments equaled 0.18%, 0.50% and 0.47% of our total revenues in fiscal 2005, 2004 and 2003, respectively. INCOME TAX EXPENSE AND ACCRUALS Our annual income tax rate is based upon our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual income tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are likely to be challenged and that we may not succeed. We adjust these reserves in light of changing facts and circumstances, such as the result of a tax audit. An estimated effective annual income tax rate is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time. Tax law requires items to be included in the income tax return at different times than the items are reflected in the financial statements. As a result, our annual income tax rate reflected in our financial statements is different than that reported in our tax return (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our income tax return, and some differences reverse over time, such as depreciation expense. These timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our income tax return in future years for which we have recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when we believe expected future taxable income is not likely to support the use of a tax deduction or credit in that tax jurisdiction. Deferred tax liabilities generally represent income tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have taken a deduction in our income tax return but have not yet recognized an expense in our financial statements. We have not recognized any United States income tax expense on undistributed international earnings since we intend to reinvest the earnings outside the United States for the foreseeable future. A number of years may elapse before a particular matter, for which we have established a reserve, is ultimately resolved. The number of years with open tax audits varies depending on the jurisdiction. While it is often difficult to predict the final outcome or the timing of resolution of any particular matter, we believe our reserves reflect the most probable outcome of known contingencies. TRADE ACCOUNTS RECEIVABLE, NET AND SALES-TYPE LEASE RECEIVABLES 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 AND OBSOLESCENCE Inventories are stated at the lower of cost (first-in, first-out method) or market. Inventories include amounts we manufacture or assemble for our long-term service contracts, which are transferred to Systems, Equipment and Other Assets Relating to Contracts 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. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Goodwill and other intangible assets determined to have indefinite useful lives are not amortized but are reviewed for impairment annually, or more frequently if events or circumstances indicate these assets may be impaired. Other intangible assets determined to have definite lives are amortized over their useful lives. We review other intangible assets with definite lives for impairment to ensure they are appropriately valued if conditions exist that may indicate the carrying value may not be recoverable. Such conditions may include, among others, significant adverse changes in the extent or manner in which an asset is being used or in legal factors or in the business climate that could affect the value of an asset. Because we have a single operating and reportable business segment (the Transaction Processing Segment), we perform our goodwill impairment 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 the 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, 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 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. OPERATIONS REVIEW Refer to the Summary Financial Data table while reading the operations review below.
SUMMARY FINANCIAL DATA Fiscal Year Ended ------------------------------------------------------------ February 26, February 28, February 22, 2005 2004 2003 ------------------ ------------------ ------------------ (Dollars in thousands) Revenues: Services $1,017,683 80.9% $ 957,471 91.1% $ 868,896 88.8% Sales of products 239,552 19.1 93,859 8.9 109,894 11.2 ---------- ----- ---------- ----- ---------- ----- Total 1,257,235 100.0 1,051,330 100.0 978,790 100.0 Costs and expenses: Costs of services (a) 616,633 60.6 537,839 56.2 535,041 61.6 Costs of sales (a) 157,974 65.9 59,226 63.1 78,943 71.8 ---------- ----- ---------- ----- ---------- ----- Total 774,607 61.6 597,065 56.8 613,984 62.7 ---------- ----- ---------- ----- ---------- ----- Gross profit 482,628 38.4 454,265 43.2 364,806 37.3 Selling, general and administrative 117,253 9.3 109,092 10.4 96,130 9.8 Research and development 52,559 4.2 57,318 5.4 42,852 4.4 Special credit -- -- -- -- (1,121) (0.1) ---------- ----- ---------- ----- ---------- ----- Operating expenses 169,812 13.5 166,410 15.8 137,861 14.1 Operating income 312,816 24.9 287,855 27.4 226,945 23.2 Other income (expense): Interest income 4,615 0.4 5,733 0.5 3,837 0.4 Equity in earnings of unconsolidated affiliates 2,812 0.2 6,236 0.6 7,376 0.8 Other income 5,356 0.4 1,889 0.2 2,175 0.2 Interest expense (19,213) (1.5) (10,919) (1.0) (11,267) (1.2) ---------- ----- ---------- ----- ---------- ----- (6,430) (0.5) 2,939 0.3 2,121 0.2 ---------- ----- ---------- ----- ---------- ----- Income before income taxes 306,386 24.4 290,794 27.7 229,066 23.4 Income taxes 109,992 8.8 107,594 10.3 87,045 8.9 ---------- ----- ---------- ----- ---------- ----- Net income $ 196,394 15.6% $ 183,200 17.4% $ 142,021 14.5% ========== ===== ========== ===== ========== =====
(a) Percentages are computed based on cost as a percentage of related revenue. COMPARISON OF FISCAL 2005 WITH 2004 TOTAL REVENUES
Fiscal Year Ended --------------------------------------------- Change February 26, February 28, --------------- 2005 2004 $ % ------------ ------------ ------ ------ (dollars in millions) Services $ 1,017.7 $ 957.4 $ 60.3 6.3 Sales of products 239.5 93.9 145.6 >100.0 ------------ ------------ ------ ------ $ 1,257.2 $ 1,051.3 $205.9 19.6 ============ ============ ====== ======
SERVICE REVENUES AND GROSS MARGIN
Fiscal Year Ended --------------------------------------------- Change February 26, February 28, --------------- 2005 2004 $ % ------------ ------------ ------ ---- (dollars in millions) Domestic lottery $ 520.6 $ 504.1 $ 16.5 3.3 International lottery 381.9 359.5 22.4 6.2 Commercial services 84.8 74.3 10.5 14.1 Gaming solutions 27.4 16.9 10.5 62.1 All other 3.0 2.6 0.4 15.4 ------------ ------------ ------ ---- $ 1,017.7 $ 957.4 $ 60.3 6.3 ============ ============ ====== ====
Fiscal Year Ended --------------------------------------------- Change February 26, February 28, ----------------- 2005 2004 Percentage Points ------------ ------------ ----------------- Service gross margin 39.4% 43.8% (4.4)
The 3.3% increase in domestic lottery service revenues was primarily due to higher service revenues from an increase in sales by our domestic lottery customers of approximately 6%, the launch of our new service contract in Tennessee and the impact of the Interlott acquisition, partially offset by contractual rate changes, lower jackpot activity and the extra week of service revenues in fiscal 2004. While we are not able to quantify precisely the reasons for increases in sales by our domestic lottery customers, we believe that in general, such increases are attributable to enhanced marketing efforts by state lottery authorities seeking to offset declining tax revenues and the successful introduction by state lottery authorities of new games and products, modifications to existing games (such as matrix changes and more frequent drawings) and expanded distribution channels, such as Keno. The 6.2% increase in international lottery service revenues includes higher service revenues from an increase in sales by our international lottery customers of approximately 2%, along with favorable foreign exchange rates and higher jackpot activity, partially offset by lower revenues from Brazil related to the court order to withhold 30% of our revenues. While we are not able to quantify precisely the reasons for increases in sales by our international lottery customers, we believe that in general, such increases are attributable to more rapid growth rates typical of newer lottery jurisdictions, the successful introduction of new games and modifications to existing games (such as matrix changes and more frequent drawings). The 14.1% increase in commercial transaction processing service revenues includes higher service revenues from an increase in sales by our commercial transaction processing customers of approximately 14%, along with favorable foreign exchange rates and the impact of the BillBird acquisition, partially offset by lower revenues from Brazil related to the court order to withhold 30% of our revenues. The 62.1% increase in gaming solutions service revenues was primarily due to the acquisition of Spielo and the installation of additional video lottery terminals in the state of Rhode Island. Our service margins were down 4.4 percentage points from last year primarily due to lower margins from Brazil related to lower service revenues resulting from the court order to withhold 30% of our revenues along with higher legal costs, and the impact of higher depreciation and amortization related principally to acquisitions, contract renewals and the implementation of new contracts. PRODUCT REVENUES AND GROSS MARGIN
Fiscal Year Ended ----------------------------------------------- Change February 26, February 28, --------------- 2005 2004 $ % ------------ ------------ ------ ------ (dollars in millions) Sales of products $ 239.6 $ 93.9 $145.7 >100.0
Fiscal Year Ended ----------------------------------------------- Change February 26, February 28, ----------------- 2005 2004 Percentage Points ------------ ------------ ----------------- Product gross margin 34.1% 36.9% (2.8)
Product sales were higher principally due to the sale of lottery terminals and a communications network to our customer in Belgium, the sale of an Enterprise Series central system to our customer in West Lotto, Germany, the sale of lottery terminals to our customer in Spain, and the impact of the Spielo acquisition. Our product margins fluctuate depending on the mix, volume and timing of product sales contracts and our current year product margins were down 2.8 percentage points primarily due to lower margins associated with the Germany central system sale. OPERATING EXPENSES Operating expenses are comprised of selling, general and administrative (SG&A) expenses and research and development (R&D) expenses.
Fiscal Year Ended --------------------------------------------- Change February 26, February 28, ------------- 2005 2004 $ % ------------ ------------ ----- ---- (dollars in millions) SG&A expenses $ 117.2 $ 109.1 $ 8.1 7.4 R&D expenses 52.6 57.3 (4.7) (8.2) ------------ ------------ ----- ---- $ 169.8 $ 166.4 $ 3.4 2.0 ============ ============ ===== ==== PERCENTAGE OF TOTAL REVENUE SG&A expenses 9.3% 10.4% R&D expenses 4.2% 5.5%
The $8.1 million increase in SG&A expenses was principally due to the current year acquisition of Spielo, along with an acceleration in regulatory licensing activity in worldwide commercial gaming markets, partially offset by lower incentive compensation costs. The $4.7 million decrease in R&D expenses was primarily due to the timing of development initiatives, partially offset by the impact of the Spielo acquisition.
EQUITY EARNINGS Fiscal Year Ended --------------------------------------------- Change February 26, February 28, ------------- 2005 2004 $ % ------------ ------------ ----- ----- (dollars in millions) Equity earnings $ 2.8 $ 6.2 $(3.4) (54.8)
Equity earnings were down $3.4 million from last year, primarily due to the sale in April 2004 of our 50% interest in Gaming Entertainment (Delaware) L.L.C. to Harrington Raceway, Inc. OTHER INCOME (EXPENSE) The components of other income in fiscal 2005 and fiscal 2004 are as follows:
Fiscal Year Ended --------------------------------------------- Change February 26, February 28, --------------- 2005 2004 $ % ------------ ------------ ----- ------- (dollars in millions) Gain on sale of investment $ 10.9 $ -- $10.9 100.0 Foreign exchange losses (1.4) (0.2) (1.2) (>100.0) Minority interest in consolidated subsidiaries (3.8) (4.5) 0.7 >100.0 One-time, non-cash gain -- 5.3 (5.3) (100.0) Other (0.3) 1.3 (1.6) (>100.0) ------------ ------------ ----- ------- $ 5.4 $ 1.9 $ 3.5 (>100.0) ============ ============ ===== =======
The $10.9 million gain on sale of investment resulted from the sale in April 2004 of our 50% interest in Gaming Entertainment (Delaware) L.L.C. to Harrington Raceway, Inc. Minority interest in consolidated subsidiaries principally relates to our controlling interests in PolCard S.A ("PolCard") and Wireless Business Solutions (Proprietary) Limited ("WBS"). PolCard is the leading debit and credit card merchant transaction acquirer and processor in Poland. WBS is a telecommunications provider in South Africa. In fiscal 2005, we determined that we no longer had a controlling interest in WBS that would require consolidation in our financial statements due principally to the expiration of our guarantee of loans made by an unrelated commercial lender to WBS and we now account for WBS using the equity method of accounting. The $5.3 million one-time, non-cash, pre-tax gain in the prior fiscal year resulted from the consolidation of the partnership that owns our world headquarters facilities, which was recorded in compliance with Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities". INTEREST EXPENSE
Fiscal Year Ended ----------------------------------------- Change February 26, February 28, ----------- 2005 2004 $ % ------------ ------------ ---- ---- (dollars in millions) Interest expense $ 19.2 $ 10.9 $8.3 76.1
Interest expense was up $8.3 million over last year primarily due to higher debt balances resulting from the issuance in November 2004 of $150 million of 4.50% Senior Notes and $150 million of 5.25% Senior Notes. INCOME TAXES Our effective income tax rate was 35.9% in fiscal 2005, down from 37% in fiscal 2004. The decrease is primarily due to a larger percentage of international profits taxed at rates that are lower than the U.S. statutory income tax rate and increased tax benefits relating to export sales. In October 2004, the American Jobs Creation Act of 2004 (the "Act") was signed into law. Among its provisions, the Act provides for a one-time special deduction for certain qualifying dividends from foreign subsidiaries. While we continue to evaluate the Act, we do not plan to elect the one-time special deduction because of the resulting loss of foreign tax credits and because the vast majority of our permanently reinvested non-U.S. earnings have been deployed in active non-U.S. business operations. WEIGHTED AVERAGE DILUTED SHARES Weighted average diluted shares in fiscal 2005 was comparable to fiscal 2004. We adopted EITF 04-8 in December 2004, which requires the inclusion of all 12.7 million shares underlying our $175 million principal amount of 1.75% Convertible Debentures in prior periods' diluted earnings per share computations, if dilutive, regardless of whether the conversion requirements have been met. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02 in fiscal 2004. COMPARISON OF FISCAL 2004 WITH 2003 TOTAL REVENUES
Fiscal Year Ended ---------------------------------------------- Change February 28, February 22, ---------------- 2004 2003 $ % ------------ ------------ ------ ----- (dollars in millions) Services $ 957.4 $ 868.9 $ 88.5 10.2 Sales of products 93.9 109.9 (16.0) (14.6) ------------ ------------ ------ ----- $ 1,051.3 $ 978.8 $ 72.5 7.4 ============ ============ ====== =====
SERVICE REVENUES AND GROSS MARGIN
Fiscal Year Ended ---------------------------------------------- Change February 28, February 22, -------------- 2004 2003 $ % ------------ ------------ ----- ---- (dollars in millions) Domestic lottery $ 504.1 $ 477.4 $26.7 5.6 International lottery 359.5 324.1 35.4 10.9 Commercial services 74.3 48.9 25.4 51.9 Gaming solutions 16.9 15.8 1.1 7.0 All other 2.6 2.7 (0.1) (3.7) ------------ ------------ ----- ---- $ 957.4 $ 868.9 $88.5 10.2 ============ ============ ===== ====
Fiscal Year Ended ----------------------------------------------- February 28, February 22, Change 2004 2003 Percentage Points ------------ ------------ ----------------- Service gross margin 43.8% 38.4% 5.4
The 5.6% increase in domestic lottery service revenues was primarily due to higher service revenues from an increase in sales by our domestic lottery customers of approximately 4% with the balance principally due to the combined effect of an extra week of service revenues in fiscal 2004 and the acquisition of Interlott. While we are not able to quantify precisely the reasons for increases in sales by our domestic lottery customers, we believe that in general, such increases are attributable to enhanced marketing efforts by state lottery authorities seeking to offset declining tax revenues and the successful introduction by state lottery authorities of new games and products, modifications to existing games (such as matrix changes and more frequent drawings) and expanded distribution channels, such as Keno. The 10.9% increase in international lottery service revenues includes higher service revenues from an increase in sales by our international lottery customers of approximately 9%, along with the impact of the effect of an extra week of service revenues in fiscal 2004 of approximately 1.5%, with the balance of the increase due to the combined impact of favorable foreign exchange rates partially offset by contractual rate changes. While we are not able to quantify precisely the reasons for increases in sales by our international lottery customers, we believe that in general, such increases are attributable to more rapid growth rates typical of newer lottery jurisdictions, the successful introduction of new games and modifications to existing games (such as matrix changes and more frequent drawings). The 51.9% increase in commercial transaction processing services was primarily due to the acquisition of PolCard, which contributed $21.4 million of service revenues in fiscal 2004. Our service margins were up 5.4 percentage points from last year, primarily due to lower depreciation of approximately 2.0 percentage points, principally related to fully depreciated assets associated with our contract with Caixa Economica Federal in Brazil, with the balance of the increase primarily due to the impact of higher service revenues. PRODUCT REVENUES AND GROSS MARGIN
Fiscal Year Ended ---------------------------------------------- Change February 28, February 22, -------------- 2004 2003 $ % ------------ ------------ ------ ----- (dollars in millions) Sales of products $ 93.9 $ 109.9 $(16.0) (14.6)
Fiscal Year Ended ----------------------------------------------- February 28, February 22, Change 2004 2003 Percentage Points ------------ ------------ ----------------- Product gross margin 36.9% 28.2% 8.7
Significant product sales in the prior year included the sale of a turnkey system to our customer in Portugal, and significant product sales in the current year included the sale of an interactive system to our customer in the United Kingdom. Our product margins were up 8.7 percentage points over last year, primarily due to the different mix of sales. OPERATING EXPENSES Operating expenses are comprised of selling, general and administrative (SG&A) expenses, research and development (R&D) expenses and a special credit.
Fiscal Year Ended ----------------------------------------------- Change February 28, February 22, --------------- 2004 2003 $ % ------------ ------------ ------ ----- (dollars in millions) SG&A expenses $ 109.1 $ 96.1 $13.0 13.5 R&D expenses 57.3 42.9 14.4 33.6 Special credit -- (1.1) 1.1 100.0 ------------ ----------- ----- ----- $ 166.4 $ 137.9 $28.5 20.7 ============ =========== ===== ===== PERCENTAGE OF TOTAL REVENUE SG&A expenses 10.4% 9.8% R&D expenses 5.5% 4.4%
The $13.0 million increase in SG&A expenses was primarily driven by increased business development activities in Poland and Mexico associated with our commercial services business and the consolidation of PolCard and Interlott. The $14.4 million increase in R&D expenses was primarily due to our continued efforts to accelerate the development and deployment of Enterprise Series into the marketplace. INTEREST INCOME
Fiscal Year Ended --------------------------------------------- Change February 28, February 22, -------------- 2004 2003 $ % ------------ ------------ ---- ---- (dollars in millions) Interest income $ 5.7 $ 3.8 $1.9 50.0
Interest income was up $1.9 million reflecting interest earned on the cash proceeds from the $250 million of debt issued in the third quarter of fiscal 2004. EQUITY EARNINGS
Fiscal Year Ended --------------------------------------------- Change February 28, February 22, --------------- 2004 2003 $ % ------------ ------------ ----- ----- (dollars in millions) Equity earnings $ 6.2 $ 7.4 $(1.2) (16.2)
Equity earnings were down $1.2 million due to lower equity income resulting principally from lower revenues generated by our joint venture in Taiwan. OTHER INCOME (EXPENSE) The components of other income in fiscal 2004 and fiscal 2003 are as follows:
Fiscal Year Ended ---------------------------------------------- Change February 28, February 22, ---------------- 2004 2003 $ % ------------ ------------ ----- -------- (dollars in millions) One-time, non-cash gain $ 5.3 $ -- $ 5.3 >100.0 Minority interest in consolidated subsidiaries (4.5) (0.6) (3.9) (>100.0) Foreign exchange losses (0.2) 4.2 (4.4) (>100.0) Net charges associated with the early retirement of debt -- (2.3) 2.3 >100.0 Other 1.3 0.9 0.4 44.4 ----------- ----------- ----- -------- $ 1.9 $ 2.2 $(0.3) (13.6) =========== =========== ===== ========
The $5.3 million one-time, non-cash, pre-tax gain resulting from the consolidation of the partnership that owns our world headquarters facilities was recorded in compliance with Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities". INCOME TAXES Our effective income tax rate decreased from 38% in fiscal 2003 to 37% in fiscal 2004 principally due to a larger percentage of international profits taxed at rates that are lower than the U.S. statutory tax rate. WEIGHTED AVERAGE DILUTED SHARES Weighted average diluted shares in fiscal 2004 increased by 3.1 million shares to 132.6 million shares. We adopted EITF 04-8 in December 2004, which requires the inclusion of all 12.7 million shares underlying our $175 million principal amount of 1.75% Convertible Debentures in prior periods' diluted earnings per share computations, if dilutive, regardless of whether the conversion requirements have been met. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02 and $0.10 in fiscal 2004 and 2003, respectively. LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION We believe our ability to generate cash from operations to reinvest in our business is one of our fundamental financial strengths and we expect to meet our financial commitments and operating needs in the foreseeable future. We expect to use cash generated from operating activities primarily for contractual obligations and to pay dividends. We expect our growth to be financed through a combination of cash generated from operating activities, existing sources of liquidity, access to capital markets and other sources of capital. Our debt ratings of Baa1 (stable outlook) from Moody's and BBB (stable outlook) from Standard and Poor's contribute to our ability to access capital markets at attractive prices. ANALYSIS OF CASH FLOWS During fiscal 2005, we generated $375.2 million of cash from operations. This cash, along with cash generated by the sale of available-for-sale investment securities, was principally used to fund the Spielo, LILHCo and BillBird acquisitions of $200.7 million and to fund $245.6 million of systems, equipment and other assets relating to contracts. In addition, we issued $300 million of Senior Notes during the third quarter of fiscal 2005; repaid the remaining $90.0 million of our 7.87% Senior Notes; repurchased $120.7 million, or 5,262,900 shares of our common stock; and paid cash dividends of $39.8 million. At February 26, 2005, we had $94.4 million of cash and cash equivalents and $196.8 million of short-term investment securities on hand. Our business is capital-intensive. We currently estimate that net cash to be used for investing activities in fiscal 2006 will be in the range of $240 million to $250 million. We expect our principal sources of liquidity to be existing cash and short-term investment securities balances, along with cash we generate from operations and borrowings under our revolving credit facility. Our credit facility provides for an unsecured revolving line of credit of $500 million and matures in October 2009. There were no borrowings under the credit facility as of February 26, 2005. Up to $100 million of the Credit Facility may be used for the issuance of letters of credit. As of February 26, 2005, after considering $7.8 million of letters of credit issued and outstanding, there was $492.2 million available for borrowing under the credit facility. The credit facility contains various covenants, including among other things, requirements relating to the maintenance of certain financial ratios. None of these covenants are expected to impact our liquidity or capital resources. There are no covenants in our credit facility that restrict our ability to pay dividends. At February 26, 2005 we were in compliance with all applicable covenants. We currently expect that our cash flow from operations, existing cash, available borrowings under our credit facility and access to additional sources of capital will be sufficient, for the foreseeable future, to fund our anticipated working capital and ordinary capital expenditure needs, to service our debt obligations, to fund anticipated internal growth, to fund all or a portion of the cash needed for potential acquisitions, to pay dividends, to fund the capital requirements under our Master Contract with the Rhode Island Lottery and to repurchase shares of our common stock, from time to time, under our share repurchase programs. We may also seek alternative sources of financing to fund certain of our obligations under our Master Contract with the Rhode Island Lottery and to fund future potential acquisitions and growth opportunities that are not currently contemplated in the $240 million to $250 million we estimate we will need in fiscal 2006 for the uses disclosed above. FINANCIAL POSITION Our balance sheet as of February 26, 2005, as compared to our balance sheet as of February 28, 2004, was impacted by the acquisitions of Spielo, LILHCo and BillBird. Drivers of the material changes in each specific balance sheet category are described below. Trade accounts receivable, net increased by $49.8 million, from $118.9 million at February 28, 2004 to $168.7 million at February 26, 2005, primarily due to current year receivables from product sale customers in Spain and Germany and receivables at PolCard, Spielo and BillBird. Inventories decreased by $15.7 million, from $76.8 million at February 28, 2004 to $61.1 million at February 26, 2005, primarily due to lower inventory related to the sale of lottery terminals and a communications network to our customer in Belgium, along with lower inventory related to the sale of an Enterprise Series central system to our customer in West Lotto, Germany, partially offset by inventory associated with the acquisition of Spielo. Systems, equipment and other assets relating to contracts, net, increased by $129.0 million, from $591.4 million at February 28, 2004 to $720.4 million at February 26, 2005, primarily due to the purchase of $245.6 million of systems, equipment and other assets relating to contracts (principally related to spending in Florida, Wisconsin and Illinois, along with the acquisitions of Spielo and LILHCo), partially offset by depreciation expense. Goodwill, net, increased by $142.4 million, from $188.6 million at February 28, 2004 to $331.0 million at February 26, 2005 primarily due to the acquisitions of Spielo, LILHCo and BillBird. Intangible assets, net, increased by $42.6 million, from $28.2 million at February 28, 2004 to $70.8 million at February 26, 2005 due to intangible assets recorded as a result of our acquisitions of Spielo, LILHCo and BillBird. Sales-type lease receivables decreased by $12.9 million, from $17.7 million at February 28, 2004 to $4.8 million at February 26, 2005, primarily due to the deconsolidation of our 40% interest in Wireless Business Solutions (Proprietary) Limited ("WBS"). In fiscal 2005, we determined that we no longer had a controlling interest in WBS that would require consolidation in our financial statements due principally to the expiration of our guarantee of loans made by an unrelated commercial lender to WBS and we now account for WBS using the equity method of accounting. Accounts payable increased by $19.2 million, from $80.0 million at February 28, 2004 to $99.2 million at February 26, 2005, primarily due to the acquisitions of Spielo, LILHCo and BillBird. Employee compensation decreased by $12.1 million, from $34.0 million at February 28, 2004 to $21.9 million at February 26, 2005, primarily due to lower provisions for incentive compensation, along with the elimination of profit sharing. Advance payments from customers decreased by $61.2 million, from $104.1 million at February 28, 2004 to $42.9 million at February 26, 2005, primarily due to the recognition of sales of lottery terminals and a communications network to our customer in Belgium and Enterprise Series central system to our customer in West Lotto, Germany. Deferred revenue and advance billings increased by $15.2 million, from $14.5 million at February 28, 2004 to $29.7 million at February 26, 2005, primarily due to deferred revenue related to a central system sale to our customer in West Lotto, Germany, along with customer progress billings related to product sales expected to be recorded in the first quarter of fiscal 2006. Current portion of long-term debt decreased by $103.8 million, from $106.3 million at February 28, 2004 to $2.5 million at February 26, 2005, primarily due to the repurchase in the first quarter of fiscal 2005 of the remaining $90.0 million of our 7.87% Senior Notes. Long-term debt, less current portion increased by $263.1 million, from $463.2 million at February 28, 2004 to $726.3 million at February 26, 2005, primarily due to proceeds from the issuance of $150 million of 4.50% Senior Notes and $150 million of 5.25% Senior Notes during the third quarter of fiscal 2005, partially offset by the repayment of the $27.9 million loan on our world headquarters facilities. Other liabilities increased by $29.6 million, from $53.7 million at February 28, 2004 to $83.3 million at February 26, 2005, primarily due to an advance payment we received from our customer in California. Deferred income taxes increased by $44.3 million, from $61.7 million at February 28, 2004 to $106.0 million at February 26, 2005, primarily due to deferred taxes associated with the Spielo, LILHCo and BillBird acquisitions, along with accelerated tax deductions relating to depreciation on fiscal 2005 investments in systems and equipment for new and existing customer contracts. The cost of treasury shares decreased by $437.8 million, from $473.7 million at February 28, 2004 to $35.9 million at February 26, 2005, primarily due to the constructive retirement of 69.8 million treasury shares on July 29, 2004 (stated on the basis reflecting the stock split which occurred subsequent to the constructive retirement). CONTRACTUAL OBLIGATIONS As of February 26, 2005, the Company's contractual obligations, including payments due by period, are as follows (in millions):
Fiscal ---------------------------------------------------------- 2006 2007 2008 2009 2010 Thereafter Total ----- ----- ---- ---- ------ ---------- ------ Long-term debt $ 2.5 $ 2.7 $ -- $ -- $149.3 $ 574.3 $728.8 Operating leases 20.6 15.4 7.4 4.9 3.9 4.3 56.5 ----- ----- ---- ---- ------ ---------- ------ Total $23.1 $18.1 $7.4 $4.9 $153.2 $ 578.6 $785.3 ===== ===== ==== ==== ====== ========== ======
LONG-TERM DEBT In December 2001, Holdings issued, in a private placement, $175 million principal amount of 1.75% Convertible Debentures due December 15, 2021 (the "Debentures"). On or after December 15, 2006, we may redeem for cash, all or part of the Debentures at a redemption price equal to 100% of the principal amount of the Debentures, plus accrued interest up to, but not including, the date of redemption. Holders of the Debentures may require us to repurchase all or part of their Debentures on December 15, 2004, December 15, 2006, December 15, 2011 and December 15, 2016 at a price equal to 100% of the principal amount of the Debentures, plus accrued interest. We may choose to pay the purchase price in cash, shares of our common stock, or a combination of both. If we elect to pay any of the purchase price in shares, the number of shares we are required to deliver is equal to the portion of the purchase price paid in shares divided by 95% of the fair value of the shares at the time of settlement. In addition, upon a change in control of our Company occurring on or before December 15, 2021, each Debenture holder may require us to repurchase all or a portion of such holder's Debentures for cash. No Debentures were tendered for repurchase on December 15, 2004. Our scheduled debt maturities above assume holders of the Debentures do not require us to repurchase all or a part of them on December 15, 2006 and also assumes that we do not redeem them for cash on or after December 15, 2006. OPERATING LEASES We lease certain facilities, equipment and vehicles under noncancelable operating leases that expire at various dates through fiscal 2015. Certain of these leases have escalation clauses and renewal options. We are required to pay all maintenance costs, taxes and insurance premiums relating to our leased assets. The amounts included in the table above represent our future minimum lease payments for noncancelable operating leases with initial lease terms in excess of one year. COMMITMENTS 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 certain specified events 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 they will do so. The following table provides information related to potential commitments at February 26, 2005:
Total Potential Commitments --------------- (in millions) Performance bonds $ 208.1 Litigation bonds 6.8 All other bonds 4.3 --------------- $ 219.2 ===============
MASTER CONTRACT WITH THE RHODE ISLAND LOTTERY 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. Under the terms of the Master Contract, we are to invest (or cause to be invested) at least $100 million in the State of Rhode Island, in the aggregate, by December 31, 2008. We currently plan to satisfy our obligation to invest (or cause to be invested) at least $100 million in the State of Rhode Island by December 31, 2008 as follows: (i) approximately $24 million that was invested during fiscal 2004; (ii) approximately $15 million that was invested during fiscal 2005; (iii) approximately $45 million that will be invested during fiscal 2006; and (iv) the balance that will be invested during fiscal 2007. The Lottery may terminate the Master Contract in the event that we fail to meet our obligations as stated above. In addition, in July 2003 we entered into a tax stabilization agreement with the City of Providence (the "City"), whereby the City agreed to stabilize the real estate and personal property taxes payable in connection with our new world headquarters facility in the City 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. ACQUISITION OF ATRONIC In December 2004, we entered into an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") owned by the owners of the privately-held Gauselmann Group ("Gauselmann"). The remaining 50% of Atronic will be retained by the owners of Gauselmann. Atronic is a video slot machine manufacturer and develops slot machine games and customized solutions for dynamic gaming operations. The final purchase price for Atronic will be calculated through a performance-based formula equal to eight times Atronic's EBITDA (earnings before interest, taxes, depreciation and amortization) for its fiscal year ending December 31, 2006. In addition, in the 12 months after the closing, Atronic will also have the potential to receive an earn-out amount based on its 2007 performance above specified thresholds. We currently expect the all-cash transaction will have a total value of approximately $100 million to $150 million, for our 50% share, including the assumption of debt. Beginning in 2012, we have the option to purchase Gauselmann's interest in Atronic and Gauselmann has a reciprocal right to sell its interest to us at a value determined by independent appraisers. There are also mutual put/call rights that may become effective before 2012, under certain circumstances. The exercise price under these circumstances will be calculated through a performance based formula. This transaction is contingent upon regulatory and gaming license approvals and other closing conditions, and is expected to be completed on December 31, 2006. OPTION TO PURCHASE POLCARD OUTSTANDING EQUITY In May 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 leading debit and credit card merchant transaction acquirer and processor in Poland. In August 2003, PolCard's outstanding equity was owned 66.5% by us, 33.2% by two funds managed by Innova Capital Sp. z o.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, 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. Approval of this transaction by our shareholders was not required. We have three fair value options to purchase Innova's interest in PolCard, and Innova has the reciprocal right to sell its interest in PolCard to us at fair value. Each fair value option has a duration of 90 days and is to be based on an appraised value from at least two investment banks at the date of each option period. We estimate that the buyout prices of each fair value option, based on discounted cash flows, could be as follows:
Buyout Percentage of the PolCard Range of Exercise Date Commencing In Outstanding Equity Buyout Price --------------------------- ------------------ ------------------ May 2007 18.5% $29 to $44 million May 2008 9.2% $16 to $25 million May 2009 9.2% $18 to $28 million
FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY FINANCIAL RISK MANAGEMENT The primary market risk inherent in our financial instruments and exposures is the potential loss arising from adverse changes in interest rates and foreign currency exchange rates. Our exposure to commodity price changes is not considered material and is managed through our procurement and sales practices. We use various techniques to manage our market risks, including from time to time, the use of derivative instruments. We manage our exposure to counterparty credit risk by entering into financial instruments with major, financially sound counterparties with high-grade credit ratings and by limiting exposure to any one counterparty. We do not engage in currency or interest rate speculation. INTEREST RATE MARKET RISK Interest rate market risk is estimated as the potential change in the fair value of our total debt or current earnings resulting from a hypothetical 10% adverse change in interest rates. The estimated fair value of our long-term debt and change in the estimated fair value due to hypothetical changes in interest rates are as follows (dollars in millions):
Estimated Fair Value --------------------------------------------------- At February 26, 10% Increase in 10% Decrease in 2005 Interest Rates Interest Rates --------------- --------------- --------------- $250 million of 4.75% Senior Notes $ 247.9 $ 246.7 $ 249.1 $150 million of 4.50% Senior Notes 149.0 146.8 151.2 $150 million of 5.25% Senior Notes 149.0 144.5 153.7 $175 million of 1.75% Convertible Debentures 304.5 304.2 304.9
The estimated fair values above were determined by an independent investment banker. The values of the Senior Notes were determined after taking into consideration $225 million of interest rate swaps as follows:
Estimated Fair Value --------------------------------- Debt Fair Interest Rate Value Swaps Outstanding --------- ----------------- $250 million of 4.75% Senior Notes $ 247.9 $ 150.0 $150 million of 4.50% Senior Notes 149.0 50.0 $150 million of 5.25% Senior Notes 149.0 25.0
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 swap and treasury rate lock agreements. INTEREST RATE SWAP AGREEMENTS During the third quarter of fiscal 2005, in conjunction with the issuance of $300 million of Senior Notes, we entered into interest rate swap agreements that effectively convert $50 million of our Senior Notes from a fixed rate to a floating rate for the period November 2004 to December 2009 and $25 million of our Senior Notes from a fixed rate to a floating rate for the period November 2004 to December 2014. TREASURY RATE LOCK AGREEMENTS In the third quarter of fiscal 2005, we entered into agreements to lock in interest rates to hedge against potential increases to interest rates prior to the issuance of our 4.50% Senior Notes and 5.25% Senior Notes. We determined that the treasury rate lock agreements were highly effective and qualified for hedge accounting. All treasury rate lock agreements have matured. The related gains of $2.0 million were deferred and recorded in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheet at February 26, 2005 and are being amortized to interest expense over the life of the respective debt instrument. EQUITY PRICE RISK The estimated fair value of our $175 million of 1.75% Convertible Debentures and change in the estimated fair value due to hypothetical changes in the market price of our common stock is as follows (dollars in millions):
Estimated Fair Value --------------------------------------------------- 10% Increase in 10% Decrease in At February 26, Market Price of Market Price of 2005 Common Stock Common Stock --------------- --------------- --------------- $175 million of 1.75% Convertible Debentures $ 304.5 $ 333.4 $ 278.7
The estimated fair values above were determined by an independent investment banker and were based on a quoted market price of $1,740.00 per Debenture. FOREIGN CURRENCY EXCHANGE RATE RISK We are subject to foreign exchange exposures arising from current and anticipated transactions denominated in currencies other than our functional currency, which is United States dollars, and from the translation of foreign currency balance sheet accounts into United States dollar balance sheet accounts. We seek to manage our foreign exchange risk by securing payment from our customers in United States dollars, by sharing risk with our customers, by utilizing foreign currency borrowings, by leading and lagging receipts and payments, and by entering into foreign currency exchange and option contracts. In addition, a significant portion of the costs attributable to our foreign currency revenues are payable in the local currencies. In limited circumstances, but whenever possible, we negotiate clauses into our contracts that allow for price adjustments should a material change in foreign exchange rates occur. From time to time, we enter into foreign currency exchange and option contracts to reduce the exposure associated with certain firm commitments, variable service revenues and certain assets and liabilities denominated in foreign currencies, but we do not engage in foreign currency speculation. These contracts generally have maturities of 12 months or less and are regularly renewed to provide continuing coverage throughout the year. As of February 26, 2005, we had contracts for the sale of foreign currency of approximately $49.0 million (primarily Euro and pounds sterling) and the purchase of foreign currency of approximately $46.4 million (primarily Brazilian real, pounds sterling, New Taiwan dollars and Canadian dollars). Comparatively, as of February 28, 2004, we had contracts for the sale of foreign currency of approximately $63.8 million (primarily Euro and pounds sterling) and the purchase of foreign currency of approximately $45.3 million (primarily Brazilian real, pounds sterling, Swedish krona, and New Taiwan dollars). Refer to Note 13 to the consolidated financial statements for additional information. At February 26, 2005 and February 28, 2004, a hypothetical 10% adverse change in foreign exchange rates would result in a translation loss of $24.2 million and $22.6 million, respectively, that would be recorded in the equity section of our balance sheet. At February 26, 2005 and February 28, 2004, a hypothetical 10% adverse change in foreign exchange rates would result in a net pre-tax transaction loss of $3.6 million and $2.0 million, respectively, that would be recorded in current earnings after considering the effects of foreign exchange contracts currently in place. At February 26, 2005, a hypothetical 10% adverse change in foreign exchange rates would result in a net reduction of cash flows from anticipatory transactions in fiscal 2006 of $20.6 million, after considering the effects of foreign exchange contracts currently in place. The percentage of fiscal 2005 and 2004 anticipatory cash flows that were hedged varied throughout each fiscal year, but averaged 56% in fiscal 2005 compared to 63% in fiscal 2004. DIVIDEND POLICY We are committed to returning value to our shareholders. Beginning in the second quarter of fiscal 2004, we commenced paying cash dividends on our common stock of $0.085 per share, equivalent to a full-year dividend of $0.34 per share. We currently plan to continue paying dividends in the foreseeable future. SUBSEQUENT EVENTS DEVELOPMENTS IN BRAZIL As described above, a June 25, 2004 ruling (the "Ruling") in a civil action initiated by federal attorneys with Brazil's Public Ministry had the effect in fiscal 2005 of materially reducing payments that we otherwise would have received from our lottery contract with Caixa Economica Federal ("CEF"), our customer and the operator of Brazil's National Lottery, which expires in May 2005. The Ruling ordered that 30% of payments subsequent to the Ruling due to GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited in an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited in an account maintained by the Court was approximately 68 million Brazilian reals, or $26 million. In fiscal 2005, we did not recognize service revenues for the payments that were withheld from GTECH Brazil, as realization of these amounts was not reasonably assured. In July 2004 we filed an appeal of the Ruling and in March 2005 (after the close of fiscal 2005), an appellate court decision ordered that the withholding be discontinued and that all funds currently held in escrow in excess of 40 million Brazilian reals be returned to us, which amounts to $11 million of the $26 million withheld as of February 26, 2005. We received and recognized these funds as service revenue on April 13, 2005. In addition, the Ruling ordered that all assets of GTECH Brazil be identified to the Court so as to prevent their transfer or disposition, a requirement that was also subsequently reversed by the appellate court decision in March 2005. Refer to Part I, Item 3, "Legal Proceedings - Brazilian Legal Proceedings, The CEF Contract Proceedings," and Note 14 to the consolidated financial statements for detailed disclosures regarding this matter. ATRONIC As described above, in December 2004, we entered into an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") owned by the owners of the privately-held Gauselmann Group ("Gauselmann"). On March 24, 2005, we guaranteed 50% of Atronic's obligations due under a Euro 50 million (approximately $65 million at the April 20, 2005 exchange rate) loan made by an unrelated commercial lender to Atronic (the "Agreement"). Our maximum liability under this guaranty is equal to the lesser of Euro 25 million (approximately $33 million at the April 20, 2005 exchange rate) or 50% of Atronic's outstanding obligations under the Agreement. The guarantee arose in connection with our planned acquisition of Atronic on December 31, 2006. We would be required to perform under the guaranty should Atronic fail to make any interest or principal payments in accordance with the terms and conditions of the Agreement. Our guarantee expires on April 26, 2010. LOXLEY GTECH PRIVATE LIMITED We have a 49% interest in Loxley GTECH Private Limited Co. ("LGT"), which is accounted for using the equity method of accounting. LGT is a corporate joint venture that is expected to provide the online lottery system in Thailand. On March 29, 2005, in order to assist LGT with obtaining the financing they require to enable them to perform under their anticipated obligation to operate the online lottery system in Thailand, we guaranteed, along with the other 51% shareholder in LGT, Baht 1.925 billion (approximately $49 million at the April 20, 2005 exchange rate) principal amount in loans and Baht 455 million (approximately $12 million at the April 20, 2005 exchange rate) in performance bonds and trade finance facilities made to LGT by an unrelated commercial lender (collectively the "Facilities"). We are jointly and severally liable with the other shareholder in LGT for this guarantee. We would be required to perform under the guaranty should LGT fail to make interest or principal payments in accordance with the terms and conditions of the Facilities. Our guarantee obligations will not commence until LGT enters into a definitive agreement with the government, which we currently expect will take place in the second quarter of fiscal 2006, and will terminate upon the start-up of the online lottery system in Thailand, which is currently expected to occur in the fourth quarter of fiscal 2006. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our market risk disclosures are included in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" above. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders GTECH Holdings Corp. We have audited the accompanying consolidated balance sheets of GTECH Holdings Corporation and subsidiaries as of February 26, 2005 and February 28, 2004, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended February 26, 2005. Our audits also included the financial statement schedule listed in the index at item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of GTECH Holdings Corporation and subsidiaries at February 26, 2005 and February 28, 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended February 26, 2005, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in 2005 the Company retroactively changed the manner in which it calculates diluted earnings per share upon the adoption of Emerging Issues Task Force Issue No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of GTECH Holdings Corporation and subsidiaries' internal control over financial reporting as of February 26, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 22, 2005 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Boston, Massachusetts April 22, 2005 GTECH HOLDINGS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
February 26, February 28, 2005 2004 ------------ ------------ (Dollars in thousands) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 94,446 $ 129,339 Investment securities available-for-sale 196,825 221,850 Trade accounts receivable, net 168,706 118,902 Sales-type lease receivables 3,461 7,705 Refundable performance deposit 8,000 -- Inventories 61,135 76,784 Deferred income taxes 31,435 34,396 Other current assets 26,646 24,426 ------------ ------------ TOTAL CURRENT ASSETS 590,654 613,402 SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS, net 720,438 591,362 GOODWILL, net 331,022 188,612 PROPERTY, PLANT AND EQUIPMENT, net 74,558 57,576 INTANGIBLE ASSETS, net 70,839 28,231 REFUNDABLE PERFORMANCE DEPOSIT 12,000 20,000 SALES-TYPE LEASE RECEIVABLES 4,756 17,653 OTHER ASSETS 50,874 42,295 ------------ ------------ TOTAL ASSETS $ 1,855,141 $ 1,559,131 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 99,234 $ 80,004 Accrued expenses 54,227 47,428 Employee compensation 21,862 33,981 Advance payments from customers 42,865 104,128 Deferred revenue and advance billings 29,705 14,459 Income taxes payable 16,499 12,394 Taxes other than income taxes 16,572 19,459 Short-term borrowings 334 -- Current portion of long-term debt 2,476 106,319 ------------ ------------ TOTAL CURRENT LIABILITIES 283,774 418,172 LONG-TERM DEBT, less current portion 726,329 463,215 OTHER LIABILITIES 83,260 53,736 DEFERRED INCOME TAXES 106,010 61,719 COMMITMENTS AND CONTINGENCIES -- -- SHAREHOLDERS' EQUITY: Preferred Stock, par value $.01 per share - 20,000,000 shares authorized, none issued -- -- Common Stock, par value $.01 per share - 200,000,000 shares authorized, 116,551,144 and 184,590,808 shares issued; 115,006,751 and 118,395,168 shares outstanding at February 26, 2005 and February 28, 2004, respectively 1,166 923 Additional paid-in capital 278,204 266,320 Accumulated other comprehensive loss (43,227) (70,508) Retained earnings 455,537 839,270 ------------ ------------ 691,680 1,036,005 Less cost of 1,544,393 and 66,195,640 shares in treasury at February 26, 2005 and February 28, 2004, respectively (35,912) (473,716) ------------ ------------ 655,768 562,289 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,855,141 $ 1,559,131 ============ ============
See Notes to Consolidated Financial Statements GTECH HOLDINGS CORPORATION AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS
Fiscal Year Ended ------------------------------------------- February 26, February 28, February 22, 2005 2004 2003 ------------- ------------ ------------ (Dollars in thousands, except per share amounts) Revenues: Services $ 1,017,683 $ 957,471 $ 868,896 Sales of products 239,552 93,859 109,894 ------------- ------------ ------------ 1,257,235 1,051,330 978,790 Costs and expenses: Costs of services 616,633 537,839 535,041 Costs of sales 157,974 59,226 78,943 ------------- ------------ ------------ 774,607 597,065 613,984 ------------- ------------ ------------ Gross profit 482,628 454,265 364,806 Selling, general and administrative 117,253 109,092 96,130 Research and development 52,559 57,318 42,852 Special credit -- -- (1,121) ------------- ------------ ------------ Operating expenses 169,812 166,410 137,861 ------------- ------------ ------------ Operating income 312,816 287,855 226,945 Other income (expense): Interest income 4,615 5,733 3,837 Equity in earnings of unconsolidated affiliates 2,812 6,236 7,376 Other income 5,356 1,889 2,175 Interest expense (19,213) (10,919) (11,267) ------------- ------------ ------------ (6,430) 2,939 2,121 ------------- ------------ ------------ Income before income taxes 306,386 290,794 229,066 Income taxes 109,992 107,594 87,045 ------------- ------------ ------------ Net income $ 196,394 $ 183,200 $ 142,021 ============= ============ ============ Basic earnings per share $ 1.68 $ 1.57 $ 1.24 ============= ============ ============ Diluted earnings per share $ 1.50 $ 1.40 $ 1.11 ============= ============ ============ Weighted average shares outstanding - basic 116,739 116,464 114,162 ============= ============ ============ Weighted average shares outstanding - diluted 132,559 132,625 129,509 ============= ============ ============ Cash dividends declared per common share $ 0.34 $ 0.255 $ -- ============= ============ ============
See Notes to Consolidated Financial Statements GTECH HOLDINGS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Fiscal Year Ended -------------------------------------------------- February 26, February 28, February 22, 2005 2004 2003 ------------ ------------ ------------ (Dollars in thousands) OPERATING ACTIVITIES Net income $ 196,394 $ 183,200 $ 142,021 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 145,999 115,324 133,452 Intangibles amortization 12,616 3,735 4,733 Deferred income taxes 34,740 59,457 (1,567) Tax benefit related to stock award plans 11,254 10,432 8,037 Minority interest 3,799 4,502 578 Equity in earnings of unconsolidated affiliates, net of dividends received 3,461 1,672 316 Gain on sale of investment (10,924) -- -- Non-cash gain from consolidation of West Greenwich Technology Associates, L.P. -- (5,292) -- Termination of interest rate swaps -- -- 11,357 Other 16,438 10,726 2,740 Changes in operating assets and liabilities: Trade accounts receivable (48,207) 3,788 (12,007) Inventories 28,522 3,030 14,387 Accounts payable 14,248 2,186 13,734 Employee compensation (15,118) (4,231) (1,022) Advance payments from customers (33,994) 51,601 (10,109) Deferred revenue and advance billings 15,037 (2,979) 6,954 Income taxes payable 11,484 (27,649) 5,590 Other assets and liabilities (10,540) 5,565 13,062 ------------ ------------ ------------ NET CASH PROVIDED BY OPERATING ACTIVITIES 375,209 415,067 332,256 INVESTING ACTIVITIES Acquisitions (net of cash acquired) (200,730) (74,442) -- Purchases of systems, equipment and other assets relating to contracts (245,592) (268,010) (155,556) Purchases of available-for-sale investment securities (246,975) (242,050) -- Maturities and sales of available-for-sale investment securities 272,000 20,200 -- Proceeds from sale of investments 11,773 -- 2,560 Purchases of property, plant and equipment (12,875) (12,772) (5,612) Increase in restricted cash (5,112) -- -- Investments in and advances to unconsolidated subsidiaries (2,071) (2,885) -- Refundable performance deposit -- (20,000) -- License fee -- (12,500) -- ------------ ------------ ------------ NET CASH USED FOR INVESTING ACTIVITIES (429,582) (612,459) (158,608) FINANCING ACTIVITIES Net proceeds from issuance of long-term debt 343,254 252,588 -- Principal payments on long-term debt (167,692) (33,293) (47,416) Purchases of treasury stock (120,658) -- (64,032) Dividends paid (39,830) (29,977) -- Premiums and fees paid in connection with the early retirement of debt (10,610) (731) (3,434) Proceeds from stock options 13,546 23,943 16,867 Other (505) (6,324) 1,822 ------------ ------------ ------------ NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES 17,505 206,206 (96,193) Effect of exchange rate changes on cash 1,975 4,351 3,624 ------------ ------------ ------------ INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (34,893) 13,165 81,079 Cash and cash equivalents at beginning of year 129,339 116,174 35,095 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 94,446 $ 129,339 $ 116,174 ============ ============ ============
See Notes to Consolidated Financial Statements GTECH HOLDINGS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated Additional Other Outstanding Common Paid-in Comprehensive Retained Treasury Shares Stock Capital Loss Earnings Stock Total ----------- ------ ---------- ------------- --------- --------- --------- (Dollars in thousands) Balance at February 23, 2002 114,982,512 $ 461 $ 227,239 $ (100,815) $ 542,878 $(466,808) $ 202,955 Comprehensive income: Net income -- -- -- -- 142,021 -- 142,021 Other comprehensive income (loss), net of tax: Foreign currency translation, net of tax benefits of $13 million -- -- -- 5,344 -- -- 5,344 Unrecognized net gain on derivative instruments -- -- -- 91 -- -- 91 Unrealized loss on investments -- -- -- (108) -- -- (108) --------- Comprehensive income 147,348 Treasury shares purchased (4,760,000) -- -- -- -- (64,032) (64,032) Shares issued under employee stock purchase and stock award plans 497,250 -- -- -- 906 3,485 4,391 Shares issued upon exercise of stock options 2,556,900 -- (10) -- (690) 17,567 16,867 Tax benefits related to stock award plans -- -- 8,037 -- -- -- 8,037 May 2002 two-for-one stock split -- 462 -- -- (462) -- -- ----------- ------ ---------- ------------- --------- --------- --------- Balance at February 22, 2003 113,276,662 $ 923 $ 235,266 $ (95,488) $ 684,653 $(509,788) $ 315,566 Comprehensive income: Net income -- -- -- -- 183,200 -- 183,200 Other comprehensive income (loss), net of tax: Foreign currency translation, net of tax benefits of $13 million -- -- -- 26,418 -- -- 26,418 Unrecognized net loss on derivative instruments -- -- -- (1,423) -- -- (1,423) Unrealized loss on investments -- -- -- (15) -- -- (15) --------- Comprehensive income 208,180 Cash dividends on common stock ($0.255 per share) -- -- -- -- (30,178) -- (30,178) Shares issued to acquire Interlott Technologies, Inc. 1,435,130 -- 20,622 -- -- 10,212 30,834 Shares issued under employee stock purchase and stock award plans 424,024 -- -- -- 843 2,669 3,512 Shares issued upon exercise of stock options 3,259,352 -- -- -- 752 23,191 23,943 Tax benefits related to stock award plans -- -- 10,432 -- -- -- 10,432 ----------- ------ ---------- ------------- --------- --------- --------- Balance at February 28, 2004 118,395,168 $ 923 $ 266,320 $ (70,508) $ 839,270 $(473,716) $ 562,289 Comprehensive income: Net income -- -- -- -- 196,394 -- 196,394 Other comprehensive income (loss), net of tax: Foreign currency translation, net of tax benefits of $4 million -- -- -- 24,618 -- -- 24,618 Unrecognized gain on interest rate locks -- -- -- 1,988 -- -- 1,988 Unrecognized net gain on derivative instruments -- -- -- 677 -- -- 677 Unrealized loss on investments -- -- -- (2) -- -- (2) --------- Comprehensive income 223,675 Treasury stock purchased (5,262,900) -- -- -- -- (120,658) (120,658) Cash dividends on common stock ($0.34 per share) -- -- -- -- (40,101) -- (40,101) Shares issued under employee stock purchase and stock award plans 356,699 -- -- -- 724 4,409 5,133 Shares issued upon exercise of stock options 1,517,784 -- -- -- (11,320) 24,866 13,546 Stock option compensation -- -- 630 -- -- -- 630 Tax benefits related to stock award plans -- -- 11,254 -- -- -- 11,254 Treasury stock retirement -- (349) -- -- (528,838) 529,187 -- July 2004 two-for-one stock split -- 592 -- -- (592) -- -- ----------- ------ ---------- ------------- --------- --------- --------- Balance at February 26, 2005 115,006,751 $1,166 $ 278,204 $ (43,227) $ 455,537 $ (35,912) $ 655,768 =========== ====== ========== ============= ========= ========= =========
See Notes to Consolidated Financial Statements GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION GTECH Holdings Corporation ("Holdings") is a global gaming and technology company providing software, networks and professional services that power high-performance, transaction processing systems. We are the world's leading operator of highly-secure online lottery transaction processing systems, doing business in 54 countries worldwide and we have a growing presence in commercial gaming technology and financial services transaction processing. We have a single operating and reportable business segment, the Transaction Processing segment. In these notes, the terms "Holdings," "Company," "we," "our," and "us" refer to GTECH Holdings Corporation and all subsidiaries included in the consolidated financial statements. Holdings conducts business through its consolidated subsidiaries and unconsolidated affiliates and has, as its only material asset, an investment in GTECH Corporation ("GTECH"), its wholly-owned subsidiary. BASIS OF PRESENTATION AND CONSOLIDATION Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and include the accounts of Holdings, GTECH, and all majority-owned or controlled subsidiaries. We consolidate all entities that we control as well as variable interest entities for which we are the primary beneficiary. We use the equity method to account for our investments in 20% to 50% owned affiliates and investments in certain corporate joint ventures, providing we are able to exercise significant influence over the investee's operating and financial policies. Consolidated net income includes our share of the net earnings of these companies. We account for our investments in less than 20% owned affiliates under the cost method. All significant intercompany accounts and transactions have been eliminated. We operate on a 52-week or 53-week fiscal year ending on the last Saturday in February. Fiscal 2005 and 2003 were 52-week years. Fiscal 2004 was a 53-week year and we included the extra week in our fourth quarter ended February 28, 2004. Certain amounts in the prior years' financial statements have been reclassified to conform to the current year presentation. REVENUE RECOGNITION LOTTERY AND GAMING TRANSACTION PROCESSING SERVICES We generally conduct our lottery and gaming business under two types of contractual arrangements: Facilities Management Contracts and Product Sales Contracts. FACILITIES MANAGEMENT CONTRACTS A majority of our revenues are derived from facilities management contracts, under which we construct, install, operate and retain ownership of the online lottery system ("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 ticket sales or a percentage of net machine income. These fees are recognized as revenue in the period earned and are classified as Service Revenue in our Consolidated Income Statements when all of the following criteria are met: - Persuasive evidence of an arrangement exists, which is typically when a customer contract has been signed - Services have been rendered - Our fee is deemed to be fixed or determinable and free of contingencies or significant uncertainties - Collectibility is reasonably assured In instances where customer acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PRODUCT SALES CONTRACTS Under product sales contracts, we construct, sell, deliver and install a turnkey lottery system or deliver lottery equipment, and license the computer software for a fixed price, and the lottery authority subsequently operates the lottery system. Product sale contracts generally include customer acceptance provisions and general customer rights to terminate the contract if we are in breach of the contract. Because product sales contracts include significant customization, 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 classified as Sales of Products in our Consolidated Income Statements and is recognized upon customer acceptance as long as there are no substantial doubts regarding collectibility. Whenever we enter into a product sale contract that involves the delivery or performance of multiple products and services that include the development and customization of software, implementation services, and licensed software and support services, we apply the consensus of EITF 00-21 "Revenue Arrangements with Multiple Deliverables", to determine whether the non-customization related deliverables specified in the contract should be treated as separate units of accounting for revenue recognition purposes. If the elements qualify as separate units of accounting, and fair value exists for the elements of the contract that are unrelated to the customization services, these elements are accounted for separately, and the related revenue is recognized as the products are delivered or the services are rendered. The application of revenue recognition principles requires judgment, including whether our product sales contracts include multiple elements, and if so, whether fair value exists for those elements. As a result, contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, the relative fair value that should be allocated to each of the elements and when to recognize revenue for each element. Our interpretation would not affect the amount of revenue recognized but could impact the timing of revenue recognition. Revenues attributable to any ongoing services provided subsequent to customer acceptance are classified as Service Revenue in our Consolidated Income Statements in the period earned. In certain product sale contracts (primarily the stand alone sale of lottery or video lottery terminals and software deliverables that do not involve significant customization of software), we are not responsible for installation. In these cases, we recognize revenue when all of the following criteria are met: - Persuasive evidence of an arrangement exists, which is typically when a customer contract has been signed - The product has been delivered - Our fee is deemed to be fixed or determinable and free of contingencies or significant uncertainties - Collectibility is reasonably assured In instances where installation and/or customer acceptance of the product is required, revenue is deferred until installation is complete and any acceptance criteria have been met. Our typical payment terms under product sale contracts include customer progress payments based on specific contract milestones with final payment due on or shortly after customer acceptance. We do not generally offer our customers payment terms that extend substantially beyond customer acceptance. In the rare case that we provide a customer with extended payment terms, we defer revenue equal to the amount of the extended payment until it is received. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) NON-LOTTERY TRANSACTION PROCESSING SERVICES We offer high-volume transaction processing services outside of our core market of providing online lottery services that consist of the acquiring, processing and transmission of commercial non-lottery transactions. Such transactions include retail debit, credit and charge card transactions, bill payments, electronic tax payments, utility payments, prepaid cellular telephone recharges and retail-based programs. We earn a fee for processing commercial non-lottery transactions that is transaction-based (a fixed fee per transaction or a fee based on a percentage of dollar volume processed). We recognize these fees as service revenue at the time a transaction is processed based on the net amount retained in accordance with Emerging Issues Task Force Issue No. 99-19, "Reporting Revenue Gross as a Principal Versus Net as an Agent." DEFERRED REVENUE AND LIQUIDATED DAMAGE ASSESSMENTS Amounts received from customers in advance of revenue recognition are recorded in Advance Payments from Customers in our Consolidated Balance Sheets. We record liquidated damage assessments, which are penalties incurred due to a failure to meet specified deadlines or performance standards, as a reduction of revenue in the period they become probable and estimable. Liquidated damage assessments equaled 0.18%, 0.50% and 0.47% of our total revenues in fiscal 2005, 2004 and 2003, respectively. STOCK-BASED COMPENSATION We have stock-based compensation plans which are described in detail in "Note 18 - 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 ("SFAS 148"), "Accounting for Stock-Based Compensation - Transition and Disclosure," an amendment of Statement of Financial Accounting Standards No. 123 ("SFAS 123"). Accordingly, no compensation expense has been recognized for our stock-based compensation plans other than for restricted stock. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (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. Forfeitures are recognized as they occur. Also disclosed in the table below are the principal weighted average assumptions used to estimate the fair value of the grants.
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands, except per share amounts) Net income, as reported $ 196,394 $ 183,200 $ 142,021 Add: Stock-based compensation expense included in reported net income, net of related tax effects 3,134 2,067 2,027 Deduct: Total stock-based compensation expense determined under the fair value method for all awards, net of related tax effects (8,006) (6,540) (8,785) ----------------- ----------------- ----------------- Pro forma net income $ 191,522 $ 178,727 $ 135,263 ================= ================= ================= Basic earnings per share: As reported $ 1.68 $ 1.57 $ 1.24 Pro forma 1.64 1.53 1.18 Diluted earnings per share: As reported $ 1.50 $ 1.40 $ 1.11 Pro forma 1.46 1.36 1.06 Estimated weighted average fair value of options granted per share $ 9.00 $ 5.00 $ 4.00 Principal assumptions: Risk-free interest rate 3.1% 2.4% 4.3% Expected life (in years) 4.1 3.8 3.3 Expected volatility 37.6% 39.0% 40.0% Expected dividend yield 1.1% 2.0% --
USE OF ESTIMATES In conformity with generally accepted accounting principles, the preparation of our financial statements requires that we make estimates, judgments and assumptions that affect the reported amounts in our financial statements and accompanying notes. Some of our more significant estimates include estimates of future cash flows associated with long-lived assets; allocation of revenues and fair values in multiple-element arrangements; inventory obsolescence; allowance for doubtful accounts; product warranty; depreciable lives of assets; and income taxes. Our estimates are based on the facts and circumstances available at the time estimates are made, historical experience, contract terms, risk of loss, general economic conditions and trends, and our assessment of the probable future outcome of these matters. Actual results may ultimately differ from initial estimates and assumptions. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY TRANSLATION The functional currency for the majority of our foreign subsidiaries is the applicable local currency. For those subsidiaries, we translate assets and liabilities at exchange rates in effect at the balance sheet date, and income and expense accounts at weighted average exchange rates. The resulting foreign currency translation adjustments are recorded in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheets. Gains or losses resulting from foreign currency transactions are recorded in our Consolidated Income Statements. We recognized net foreign exchange gains (losses) as a component of Service Revenue and Other Income (Expense) in our Consolidated Income Statements as follows:
Fiscal Year Ended ----------------------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Service revenue $ (2,357) $ (3,601) $ (3,247) Other income (expense) (1,365) (185) 4,237 ----------------- ----------------- ----------------- Total net foreign exchange gains (losses) $ (3,722) $ (3,786) $ 990 ================= ================= =================
For those foreign subsidiaries operating in a highly inflationary economy or whose functional currency is the United States dollar, nonmonetary assets and liabilities are translated at historical rates and monetary assets and liabilities are translated at current rates. The resulting foreign currency translation adjustments are recorded in Cost of Services in our Consolidated Income Statements. DERIVATIVES AND HEDGING TRANSACTIONS We use derivative financial instruments principally to manage the risk of foreign currency exchange rate and interest rate fluctuations and we account for our derivative financial instruments in accordance with Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities," as amended. SFAS 133 requires that all derivative instruments be reported on the balance sheet at fair value and establishes criteria for the designation and the assessment of the effectiveness of hedging relationships. From time to time, we enter into foreign currency exchange and option contracts to reduce the exposure associated with certain firm commitments, variable service revenues and certain assets and liabilities denominated in foreign currencies. These contracts generally have maturities of 12 months or less and are regularly renewed to provide continuing coverage throughout the year. We do not engage in foreign currency speculation. We record certain contracts used to provide us with a degree of protection against foreign currency exchange risk on our variable service revenues at fair value in our Consolidated Balance Sheets. The related gains or losses on these contracts are either deferred and included in Shareholders' Equity (Accumulated Other Comprehensive Loss) or immediately recognized in earnings depending on whether the contract qualifies for hedge accounting. The deferred gains and losses are subsequently recognized in earnings in the period that the related items being hedged are received and recognized in earnings. Contracts used to hedge assets and liabilities denominated in foreign currencies are recorded in our Consolidated Balance Sheets at fair value and the related gains or losses on these contracts are immediately recognized in earnings as a component of Other Income (Expense) in our Consolidated Income Statements. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INTEREST RATE SWAPS From time to time, we enter into interest rate swap agreements to mitigate our exposure to interest rate changes. The amount and term of each interest rate swap agreement is matched with all or a portion of the then outstanding principal balance and remaining term of a specific debt obligation. These agreements involve the exchange of fixed interest rates for variable interest rates over the term of the agreement without an exchange of the notional amount upon which the payments are based. The differential to be received or paid as interest rates change is accrued and recognized as an adjustment of interest expense related to the debt. The related amount receivable from or payable to counterparties is included as an asset or liability in our Consolidated Balance Sheets. Gains resulting from the early termination of interest rate swap agreements are deferred as an adjustment to the carrying amount of the outstanding debt and amortized as adjustments to interest expense over the remaining period originally covered by the terminated swap agreements. In the event of the early extinguishment of debt, any gain or loss from the swap would be recognized in earnings as a component of Other Income (Expense) in our Consolidated Income Statements in the same period as the extinguishment gain or loss. RESEARCH AND DEVELOPMENT We expense research and development costs as incurred. ADVERTISING COSTS Advertising costs are expensed as incurred and amounted to $9.3 million, $6.9 million and $10.4 million in fiscal 2005, 2004 and 2003, respectively. INCOME TAXES Deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted income tax rates and laws that are expected to be in effect when the temporary differences are expected to reverse. Additionally, deferred tax assets and liabilities are separated into current and noncurrent amounts based on the classification of the related assets and liabilities for financial reporting purposes. We establish valuation allowances for our deferred tax assets when we believe expected future taxable income is not likely to support the use of a tax deduction or credit in that tax jurisdiction. CASH AND CASH EQUIVALENTS We classify short-term, highly liquid investments with an original maturity of three months or less at the date of purchase as cash equivalents. INVESTMENT SECURITIES AVAILABLE-FOR-SALE Investment securities, which primarily consist of state and municipal auction rate securities and variable rate demand obligations, are classified as "available for sale" under the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and are recorded at fair value. We invest in short-term investments that are generally highly liquid and are assigned a minimal credit rating of A- or A3 from Standard and Poor's or Moody's Investor Service, respectively. Any unrealized gains and losses, net of income tax effects, would be computed on the basis of specific identification and reported as a component of Accumulated Other Comprehensive Loss in our Consolidated Balance Sheets. Realized gains and losses would be included in Other Income (Expense) in our Consolidated Income Statements. We did not incur any unrealized or realized gains or losses in fiscal years 2005 and 2004. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENSTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) TRADE ACCOUNTS RECEIVABLE, NET AND SALES-TYPE LEASE RECEIVABLES Trade accounts receivable are reported net of allowances for doubtful accounts and liquidated damages of $9.3 million and $10.7 million at February 26, 2005 and February 28, 2004, respectively. 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 AND OBSOLESCENCE Inventories are stated at the lower of cost (first-in, first-out method) or market. Inventories include amounts we manufacture or assemble for our long-term service contracts, which are transferred to Systems, Equipment and Other Assets Relating to Contracts 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. SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS, NET Systems, equipment and other assets relating to contracts are stated on the basis of cost. The cost, less any salvage value, is depreciated over the base contract term, not to exceed 10 years, using the straight-line method for financial reporting purposes and accelerated methods for income tax purposes. PROPERTY, PLANT AND EQUIPMENT, NET Property, plant and equipment is stated on the basis of cost. The cost is depreciated over the estimated useful life of the assets using the straight-line method for financial reporting purposes and accelerated methods for income tax purposes. The estimated useful lives are generally 10 to 30 years for buildings and five to 10 years for furniture and equipment. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CAPITALIZED COMPUTER SOFTWARE COSTS Capitalized computer software costs are comprised of amounts specific to customer contracts and amounts related to software products that are, or are anticipated to be, included in our product offerings. SPECIFIC TO CUSTOMER CONTRACTS Costs specific to customer contracts are capitalized and included in Systems, Equipment and Other Assets Relating to Contracts, net. The cost, less any salvage value, is depreciated over the base contract term, not to exceed 10 years, using the straight-line method for financial reporting purposes and accelerated methods for income tax purposes. PRODUCT OFFERINGS Costs related to product offerings are charged to research and development expense as incurred until such time as technological feasibility has been established for the product. Thereafter, they are capitalized and included in Intangible Assets, net in our Consolidated Balance Sheets and are generally amortized over five years on a straight-line basis. We periodically evaluate costs related to product offerings for impairment based on customer requirements. Unamortized computer software costs consist of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Specific to customer contracts $ 55,912 $ 42,139 Product offerings 7,627 1,556 ----------------- ----------------- $ 63,539 $ 43,695 ================= =================
Depreciation and amortization expense is included in Costs of Services or Costs of Sales in our Consolidated Income Statements and consists of the following:
Fiscal Year Ended ----------------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Specific to customer contracts $ 13,352 $ 10,447 $ 15,235 Product offerings 2,447 1,544 2,729 ----------------- ----------------- ----------------- $ 15,799 $ 11,991 $ 17,964 ================= ================= =================
GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Goodwill and other intangible assets determined to have indefinite useful lives are not amortized but are reviewed for impairment annually, or more frequently if events or circumstances indicate these assets may be impaired. Other intangible assets determined to have definite lives are amortized over their useful lives. We review other intangible assets with definite lives for impairment to ensure they are appropriately valued if conditions exist that may indicate the carrying value may not be recoverable. Such conditions may include, among others, significant adverse changes in the extent or manner in which an asset is being used or in legal factors or in the business climate that could affect the value of an asset. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Because we have a single operating and reportable business segment (the Transaction Processing Segment), we perform our goodwill impairment 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 the 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, 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 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. NEW ACCOUNTING PRONOUNCEMENTS FASB STATEMENT NO. 123R In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which is a revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation". SFAS 123R supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and amends FASB Statement No. 95, "Statement of Cash Flows". SFAS 123R requires all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than the beginning of the first fiscal year beginning after June 15, 2005 (our fiscal 2007 first quarter). Early adoption is permitted. We plan to adopt SFAS 123R on the first day of fiscal 2007 (February 26, 2006). SFAS 123R permits public companies to adopt its requirements using either the modified prospective transition ("MPT") method or the modified retrospective transition ("MRT") method. Under the MPT method, compensation cost for new awards and modified awards are recognized beginning with the effective date and the cost for awards that were granted prior to, but not vested as of the effective date, will be based on the grant date fair value estimate used for SFAS 123 pro forma disclosure purposes. The MRT method includes the requirements of the MPT method but also permits restatement of all prior periods presented or only the prior interim periods of the year of adoption. We plan to adopt SFAS 123R using the MPT method and we intend to use a lattice model to value stock options granted after February 26, 2006. We currently account for share-based payments to employees using the intrinsic value method under APB 25 and related Interpretations, and as such, we generally recognize no compensation cost for employee stock options. We currently estimate the impact of adopting SFAS 123R will be in a range of $0.04 to $0.06 per diluted share in fiscal 2007. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for these excess tax deductions were $11.3 million, $10.4 million and $8.0 million in fiscal 2005, 2004 and 2003, respectively. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FASB STAFF POSITION NO. 109-1 In December 2004, the FASB issued FASB Staff Position No. 109-1, "Application of FASB Statement No. 109, `Accounting for Income Taxes', to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004" ("FSP 109-1"). FSP 109-1 provides guidance on the application of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), to the provision of the American Jobs Creation Act of 2004 (the "Act") that provides a tax deduction on qualified production activities. The FASB staff believes that the deduction should be accounted for as a special deduction in accordance with SFAS 109 as opposed to a tax rate reduction. FSP 109-1 is effective immediately. Pursuant to the Act, we will be able to benefit from a tax deduction for qualified production activities in fiscal 2006. We will follow the provisions of this guidance when applicable. We have not yet determined the impact this tax deduction will have on our results of operations or financial position. FASB STAFF POSITION NO. 109-2 In December 2004, the FASB issued FASB Staff Position No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP 109-2"). FSP 109-2 provides for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision). FSP 109-2 provides accounting and disclosure guidance for the repatriation provision and is effective immediately. While we continue to evaluate the Act, we do not plan to elect the one-time provision because of the resulting loss of foreign tax credits and because the vast majority of our permanently reinvested non-U.S. earnings have been deployed in active non-U.S. business operations. EITF 04-8 In October 2004, the FASB ratified the Emerging Issues Task Force's consensus on Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-8"), which is effective for periods ending after December 15, 2004. Under current interpretations of FAS 128, "Earnings per Share", issuers of contingently convertible debt instruments exclude the potential common shares underlying the debt instrument from the calculation of diluted earnings per share until the contingency is met. EITF 04-8 requires that potential shares underlying the debt instrument be included in diluted earnings per share computations, if dilutive, regardless of whether the contingency has been met. We adopted EITF 04-8 in December 2004 and retroactively adjusted all prior period diluted earnings per share amounts to conform to the guidance in EITF 04-8. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02 and $0.10 in fiscal 2004 and 2003, respectively. NOTE 2 - COMMON STOCK SPLIT AND TREASURY STOCK RETIREMENT On June 17, 2004, our Board of Directors approved a 2-for-1 common stock split, payable in the form of a stock dividend, which entitled each shareholder of record on July 1, 2004 to receive one share of common stock for each outstanding share of common stock held on that date. The stock dividend was distributed on July 30, 2004. All references to common shares and per share amounts herein have been restated to reflect the stock splits for all periods presented. In connection with the declaration of the stock dividend, our Board of Directors approved the retirement of 69.8 million shares of our common stock held in treasury on July 29, 2004 (stated on a basis reflecting the stock split which occurred subsequent to the retirement). The $528.8 million of treasury stock at the time of the retirement was eliminated from treasury stock through a charge to retained earnings and common stock. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 - BUSINESS ACQUISITIONS BILLBIRD S.A. On September 9, 2004, our majority-owned subsidiary, PolCard S.A, completed the acquisition of privately-held BillBird S.A. ("BillBird"), the leading provider of electronic bill payment services in Poland, for an all-cash purchase price of approximately $6.0 million. The results of BillBird's operations have been included in the consolidated financial statements since that date. Approval of this transaction by our shareholders was not required. LEEWARD ISLANDS LOTTERY HOLDING COMPANY INC. On May 5, 2004, we completed the acquisition of privately-held Leeward Islands Lottery Holding Company Inc. ("LILHCo"), a lottery operating company headquartered on the Caribbean islands of Antigua and St. Croix, for an all-cash purchase price of approximately $40 million. The results of LILHCo's operations have been included in the consolidated financial statements since that date. Approval of this transaction by our shareholders was not required. SPIELO MANUFACTURING INCORPORATED On April 30, 2004, we completed the acquisition of privately-held Spielo Manufacturing Incorporated ("Spielo"), a leading provider of video lottery terminals ("VLT's") and related products and services to the global gaming industry, for an all-cash purchase price of approximately $150 million. In addition, we paid Spielo shareholders approximately $10.7 million out of a potential maximum earn-out amount of up to $35 million, which Spielo shareholders are entitled to receive in the 18 months following the closing, based upon Spielo achieving certain VLT installation objectives in New York and separately, a working capital adjustment of approximately $1.5 million. The results of Spielo's operations have been included in the consolidated financial statements since April 30, 2004. This acquisition will enable us to deliver complete, integrated VLT solutions to our existing and potential customers, with a single point of contact and accountability. Approval of this transaction by our shareholders was not required. The following table summarizes the estimated fair values of Spielo's assets acquired and liabilities assumed at the date of the acquisition:
Estimated Fair Values -------------- (in thousands) Current Assets $ 18,616 Systems, Equipment & Other Assets Relating to Contracts, net 13,710 Goodwill, net 112,917 Property, Plant & Equipment, net 5,646 Intangible Assets, net 31,470 Sales-Type Lease Receivables 185 Deferred Income Taxes 1,683 -------------- Total Assets Acquired 184,227 Current Liabilities 8,056 Long-Term Debt, less current portion 280 Deferred Income Taxes 12,644 -------------- Total Liabilities Assumed 20,980 Net Assets Acquired $ 163,247 ==============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 - BUSINESS ACQUISITIONS (CONTINUED) Acquired intangible assets of $31.5 million have a weighted average amortization period of approximately 6 years at February 26, 2005 as follows:
Weighted Average Gross Amortization Carrying Period Amount ---------------- -------------- (in thousands) SUBJECT TO AMORTIZATION Customer contracts 7 $ 19,840 Computer software 4 8,200 Non-compete agreement 5 370 Trademarks 4 160 -------------- 28,570 NOT SUBJECT TO AMORTIZATION Trademarks 2,900 -------------- $ 31,470 ==============
Goodwill of $112.9 million, which is not deductible for income tax purposes, was assigned to our single operating and reportable business segment, the Transaction Processing segment. 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 leading 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. z o.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, 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. Approval of this transaction by our shareholders was not required. We have three fair value options to purchase Innova's interest in PolCard, and Innova has the reciprocal right to sell its interest in PolCard to us at fair value. Each fair value option has a duration of 90 days and is to be based on an appraised value from at least two investment banks at the date of each option period. We estimate that the buyout prices of each fair value option, based on discounted cash flows, could be as follows:
Buyout Percentage of the PolCard Range of Exercise Date Commencing In Outstanding Equity Buyout Price --------------------------- ------------------ ------------------ May 2007 18.5% $29 to $44 million May 2008 9.2% $16 to $25 million May 2009 9.2% $18 to $28 million
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 - BUSINESS ACQUISITIONS (CONTINUED) INTERLOTT TECHNOLOGIES, INC. On September 18, 2003, we completed the acquisition of Interlott Technologies, Inc. ("Interlott"), a leading provider of instant ticket vending machines for the worldwide lottery industry. Interlott shareholders were given the opportunity to elect to receive either $4.50 per share in cash or a number of shares of Holdings common stock having a value of $4.50, 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 $20.87 for Holdings common stock for the 20 trading day period commencing August 14, 2003 through September 11, 2003. For purposes of purchase accounting, Holdings common stock was valued at $21.49 per share using the average price of Holdings common stock two days prior to the acquisition date in accordance with Emerging Issues Task Force Issue No. 99-12, "Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination." The aggregate purchase price, including assumed debt, was as follows:
Aggregate purchase price -------------- (in thousands) Cash ($4.50 per share of Interlott common stock) $ 28,211 Cash payment to cancel outstanding stock options relating to Interlott common stock 5,701 -------------- Cash purchase price 33,912 Issuance of 1,435,130 shares of Holdings common stock 30,834 -------------- Total aggregate purchase price 64,746 Cash payment to settle Interlott debt 22,759 -------------- $ 87,505 ==============
Approval of this transaction by our shareholders was not required EUROPRINT HOLDINGS LTD. On July 1, 1998, we acquired 80% of the equity of Europrint Holdings Ltd. ("Europrint") and its wholly owned subsidiaries, including Interactive Games International ("IGI"), 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. On June 24, 2003 (our fiscal 2004 second quarter), we exercised our option to acquire the remaining 20% of the equity of Europrint for approximately $5.1 million. Refer to Note 7 for detailed disclosures regarding Goodwill and Other Intangible Assets related to acquisitions. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 - INVENTORIES Inventories consist of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Raw materials $ 29,622 $ 14,540 Work in progress 15,492 60,470 Finished goods 16,021 1,774 ----------------- ----------------- $ 61,135 $ 76,784 ================= =================
Inventories include amounts we manufacture or assemble for our long-term service contracts and amounts related to product sales contracts, including product sales which are accounted for using SOP 81-1. Work in progress at February 26, 2005 and February 28, 2004, includes approximately $12.0 million and $54.9 million, respectively, related to product sale contracts. Amounts received from customers in advance of revenue recognition (primarily related to product sale contracts included in work in progress above) totaled $42.9 million and $104.1 million at February 26, 2005 and February 28, 2004, respectively. These amounts are included in Advance Payments from Customers in our Consolidated Balance Sheets. NOTE 5 - SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS Systems, equipment and other assets relating to contracts consist of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Land and buildings $ 1,182 $ 1,182 Computer terminals and systems 1,407,134 1,185,841 Furniture and equipment 186,891 163,562 Contracts in progress 30,407 22,603 ----------------- ----------------- 1,625,614 1,373,188 Less accumulated depreciation and amortization 905,176 781,826 ----------------- ----------------- $ 720,438 $ 591,362 ================= =================
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Land and buildings $ 43,667 $ 37,155 Furniture and equipment 124,562 114,103 Construction in progress 14,300 4,649 ----------------- ----------------- 182,529 155,907 Less accumulated depreciation and amortization 107,971 98,331 ----------------- ----------------- $ 74,558 $ 57,576 ================= =================
As described further in Note 8 "License Fee" and Note 15 "Guarantees and Indemnifications", under our Master Contract with the State of Rhode Island, we are responsible for the development of a new world headquarters facility ("Facility") in Providence, Rhode Island by December 31, 2006. We have engaged US Real Estate Limited Partnership (the "Developer") to build, own and operate this Facility. Under EITF Issue No. 97-10, "The Effect of Lessee Involvement in Asset Construction", we are considered the owner of the Facility (for accounting purposes only). Accordingly, during fiscal 2005, we capitalized approximately $6.6 million of costs incurred by the Developer. These costs are included in construction in progress within Property, Plant & Equipment, net and a corresponding liability for the same amount is included in Other Liabilities in our Consolidated Balance Sheet at February 26, 2005. NOTE 7 - GOODWILL AND OTHER INTANGIBLE ASSETS In accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), goodwill and indefinite lived intangible assets are no longer amortized but are reviewed for impairment annually, or more frequently if events or circumstances indicate that these assets may be impaired. Intangible assets deemed to have definite lives are amortized over their useful lives. The adoption of SFAS 142 required us to perform an initial impairment assessment on all goodwill and indefinite lived intangible assets as of February 24, 2002 (the first day of fiscal 2003) and we determined that no impairment existed. In connection with the adoption of the new standard, we determined that goodwill with a net book value of $1.3 million met the standards' intangible asset recognition criteria. Accordingly, we reclassified this amount during fiscal 2003 into intangible assets and we will continue to amortize it over its remaining useful life. A reconciliation of the net carrying amount of goodwill, which is not deductible for income tax purposes, is as follows:
Net Carrying Amount -------------- (in thousands) Balance as of February 22, 2003 $ 115,498 Goodwill acquired during the year 73,114 -------------- Balance as of February 28, 2004 188,612 Goodwill acquired during the year 144,532 Adjustments to purchase price allocations during the year (2,122) -------------- Balance as of February 26, 2005 $ 331,022 ==============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 - GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED) The following tables present the information for intangible assets, which are being amortized over their estimated useful lives, with no estimated residual values.
As of February 26, 2005 ----------------------------------------------------- Weighted Average Gross Net Amortization Carrying Accumulated Carrying Period Amount Amortization Amount ---------------- -------- ------------ -------- (Dollars in thousands) SUBJECT TO AMORTIZATION Customer contracts 10 $ 54,244 $ 9,810 $ 44,434 Capitalized computer software 5 24,465 16,838 7,627 License fee 20 12,500 1,038 11,462 Patents 6 5,100 1,203 3,897 Non-compete agreement 4 669 275 394 Trademarks 4 160 35 125 -------- ------------ -------- 97,138 29,199 67,939 NOT SUBJECT TO AMORTIZATION Trademarks 2,900 -- 2,900 -------- ------------ -------- $100,038 $ 29,199 $ 70,839 ======== ============ ========
The weighted average amortization period in total for intangible assets as of February 26, 2005 was 10 years.
As of February 28, 2004 ----------------------------------------------------- Weighted Average Gross Net Amortization Carrying Accumulated Carrying Period Amount Amortization Amount ---------------- -------- ------------ -------- (Dollars in thousands) SUBJECT TO AMORTIZATION Capitalized computer software 5 $ 16,018 $ 14,462 $ 1,556 License fee 20 12,500 413 12,087 Customer contracts 6 11,044 1,342 9,702 Patents 6 5,100 353 4,747 Non-compete agreement 2 222 83 139 -------- ------------ --------- $ 44,884 $ 16,653 $ 28,231 ======== ============ =========
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 - GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED) A reconciliation of the net carrying amount of intangible assets is as follows:
Fiscal Year Ended ------------------------------------- February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Balance at beginning of year $ 28,231 $ 2,190 Intangible assets acquired during the year: Purchase business combination related: Customer contracts 43,200 11,044 Capitalized computer software 8,447 1,241 Trademarks 3,060 -- Non-compete agreement 447 222 Patents -- 5,100 ----------------- ----------------- 55,154 17,607 License fee (see Note 8) -- 12,500 ----------------- ----------------- Total intangible assets acquired 55,154 30,107 Capitalized computer software -- (331) Foreign currency translation 70 -- Amortization expense (12,616) (3,735) ----------------- ----------------- Balance at end of year $ 70,839 $ 28,231 ================= =================
Purchase business combination intangible assets acquired during fiscal 2005 relate to the acquisitions of Spielo, LILHCo and BillBird (refer to Note 3 for detailed disclosures). Amortization expense for fiscal 2005, 2004 and 2003 is as follows:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Customer contracts $ 8,468 $ 1,342 $ 2,004 Capitalized computer software 2,447 1,544 2,729 Patents 850 353 -- License fee 625 413 -- Non-compete agreement 191 83 -- Trademarks 35 -- -- ----------------- ----------------- ----------------- Total intangibles amortization $ 12,616 $ 3,735 $ 4,733 ================= ================= =================
Amortization expense for the next five fiscal years and thereafter is estimated to be as follows (in thousands):
Amortization Fiscal Year Expense ----------- ------------ 2006 $ 10,043 2007 9,397 2008 8,848 2009 6,074 2010 5,333 Thereafter 28,244 ------- Total $ 67,939 =======
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8 - LICENSE FEE On May 12, 2003, we entered into a Master Contract with the Rhode Island Lottery (the "Lottery") that amends our existing contracts with the Lottery and grants us the right to be the exclusive provider of online, instant ticket and video lottery central systems and services for the Lottery during the 20-year term of the Master Contract for a $12.5 million up-front license fee which we paid in July 2003. This license fee is included in Intangible Assets, net in our Consolidated Balance Sheet at February 26, 2005 and will be amortized as a reduction in service revenue on a straight-line basis over the 20-year term of the Master Contract. (See Note 7). The Master Contract is part of a comprehensive economic development package that provides incentives for us to keep our world headquarters and manufacturing operations in Rhode Island. Under the terms of the Master Contract, we are to invest (or cause to be invested) at least $100 million in the State of Rhode Island, in the aggregate, by December 31, 2008. This investment commitment includes the $12.5 million up-front license fee; new online and video lottery related hardware, software and services; the development of a new world headquarters facility of at least 210,000 square feet in Providence, Rhode Island by December 31, 2006; and improvements to our existing manufacturing facility in West Greenwich, Rhode Island. We have agreed to employ at least 1,000 people full-time in Rhode Island by the end of calendar year 2005 and maintain that level of employment thereafter. In the event the State of Rhode Island takes certain actions which affect our financial performance, we will be automatically released from the in-state employment obligation. We currently plan to satisfy our obligation to invest (or cause to be invested) at least $100 million in the State of Rhode Island by December 31, 2008 as follows: (i) approximately $24 million that was invested during fiscal 2004; (ii) approximately $15 million that was invested during fiscal 2005; (iii) approximately $45 million that will be invested during fiscal 2006; and (iv) the balance that will be invested during fiscal 2007. In addition, in July 2003 we entered into a tax stabilization agreement (the "Agreement") with the City of Providence (the "City"), whereby the City agreed to stabilize the real estate and personal property taxes payable in connection with our new world headquarters facility in the City 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. The Lottery may terminate the Master Contract in the event that we fail to meet our obligations as stated above. NOTE 9 - REFUNDABLE PERFORMANCE DEPOSIT In September 2003 (our fiscal 2004 third quarter), we entered into a 12-year contract extension to provide online lottery products and services to SAZKA, a.s. ("SAZKA"), the operator of lottery and betting games in the Czech Republic. The contract extension will commence on January 1, 2006 and expires on December 31, 2017. As part of the contract extension, we paid SAZKA a $20 million performance deposit that SAZKA will repay upon the achievement of certain milestones beginning in 2006. The performance deposit is scheduled to be repaid as follows:
(in thousands) -------------- On or before January 2, 2006 $ 8,000 On or before January 2, 2007 8,000 On or before January 2, 2008 2,000 On or before January 2, 2009 1,000 On or before January 2, 2010 1,000 -------------- $ 20,000 ==============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - RESTRICTED ASSETS A June 25, 2004 ruling (the "Ruling") in a civil action initiated by federal attorneys with Brazil's Public Ministry had the effect in fiscal 2005 of materially reducing payments that we otherwise would have received from our lottery contract with Caixa Economica Federal ("CEF"), our customer and the operator of Brazil's National Lottery, which expires in May 2005. The Ruling ordered that 30% of payments subsequent to the Ruling due to GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited in an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited in an account maintained by the Court was approximately 68 million Brazilian reals, or $26 million. In fiscal 2005, we did not recognize service revenues for the payments that were withheld from GTECH Brazil, as realization of these amounts was not reasonably assured. In July 2004 we filed an appeal of the Ruling and in March 2005 (after the close of fiscal 2005), an appellate court decision ordered that the withholding be discontinued and that all funds currently held in escrow in excess of 40 million Brazilian reals be returned to us, which amounts to $11 million of the $26 million withheld as of February 26, 2005. We received and recognized these funds as service revenue on April 13, 2005. Refer to Note 14 for detailed disclosures regarding this matter. In addition, the Ruling ordered that all assets of GTECH Brazil be identified to the Court so as to prevent their transfer or disposition, a requirement that was also subsequently reversed by the appellate court decision in March 2005. As of February 26, 2005, GTECH Brazil assets were as follows (in thousands): Cash $ 5,080 Systems, Equipment and Other Assets Relating to Contracts, net 5,669 ------- Assets restricted from transfer or disposition $10,749 All other assets 24,156 ------- GTECH Brazil assets at February 26, 2005 $34,905 =======
The restricted cash of $5.1 million is included in Other Assets in our Consolidated Balance Sheet. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 - PRODUCT WARRANTIES We offer a product warranty on all of our manufactured products (primarily terminals and related peripherals) sold to our customers. Although we do not have a standard product warranty, our typical warranty provides that we will repair or replace defective products for a period of time (usually a minimum of 90 days) from the date revenue is recognized or from the date a product is delivered and tested. We estimate product warranty costs that we expect to incur during the warranty period and we record a charge to costs of sales for the estimated warranty cost at the time the product sale is recorded. In determining the appropriate warranty provision, consideration is given to historical warranty cost information, the status of the terminal model in its life cycle and current terminal performance. We periodically assess the adequacy of our product warranty reserves and adjust them as necessary in the period when the information necessary to make the adjustment becomes available. We typically do not provide a product warranty on purchased products sold to our customers but attempt to pass the manufacturer's warranty, if any, on to them. A summary of product warranty activity for the twelve months ended February 26, 2005 and February 28, 2004 is as follows:
Fiscal Year Ended ------------------------------------------ February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Balance at beginning of year $ 749 $ 437 Opening reserve balance associated with acquisitions 1,126 -- Additional reserves 1,508 405 Charges incurred (1,201) (51) Change in estimate (603) (42) Other 55 -- ----------------- ----------------- Balance at end of year $ 1,634 $ 749 ================= =================
Our reserves for product warranty are included in Accrued Expenses in our Consolidated Balance Sheets. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - LONG - TERM DEBT Long-term debt consists of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) 4.75% Senior Notes due October 2010 $ 249,690 $ 249,636 1.75% Convertible Debentures due December 2021 175,000 175,000 4.50% Senior Notes due December 2009 149,604 -- 5.25% Senior Notes due December 2014 148,704 -- Fair value of interest rate swaps 541 4,893 7.87% Series B Guaranteed Senior Notes due May 2007 -- 90,000 World Headquarters loan due January 2007 -- 27,933 Deferred interest rate swap gains -- 12,009 Other, due through October 2007 5,266 10,063 ----------------- ----------------- 728,805 569,534 Less current portion 2,476 106,319 ----------------- ----------------- $ 726,329 $ 463,215 ================= =================
At February 26, 2005, long-term debt matures as follows (in thousands):
Fiscal ---------------------------------------------------------------------------------------- 2006 2007 2008 2009 2010 Thereafter Total -------- -------- -------- -------- -------- ---------- -------- Long-term debt $ 2,476 $ 2,742 $ 48 $ -- $149,255 $ 574,284 $728,805 ======== ======== ======== ======== ======== ========== ========
4.75% SENIOR NOTES In October 2003, Holdings issued, in a private placement, $250 million principal amount of 4.75% Senior Notes due October 15, 2010, all of which were subsequently exchanged for 4.75% Senior Notes due October 15, 2010 registered under the Securities Act of 1933 (the "2010 Senior Notes"). The 2010 Senior Notes are unsecured and unsubordinated obligations of Holdings that are fully and unconditionally guaranteed by GTECH and certain of its subsidiaries. Interest is payable semi-annually in arrears on April 15 and October 15 of each year. In conjunction with the 2010 Senior Notes offering, in October 2003, GTECH entered into three interest rate swap contracts that effectively convert $150 million of the 2010 Senior Notes from a fixed rate debt to a floating rate debt for the period October 15, 2003 to October 15, 2010. 1.75% CONVERTIBLE DEBENTURES In December 2001, Holdings issued, in a private placement, $175 million principal amount of 1.75% Convertible Debentures due December 15, 2021 (the "Debentures"). The Debentures are unsecured and unsubordinated obligations of Holdings that are fully and unconditionally guaranteed by GTECH and certain of its subsidiaries. Interest on the Debentures is payable semi-annually in arrears on June 15 and December 15 of each year and accrues at an initial rate of 1.75% per year, subject to reset beginning December 15, 2006 under certain circumstances. In no event will the interest rate be reset below 1.75% or above 2.5% per year. GETCH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - LONG - TERM DEBT (CONTINUED) On or after December 15, 2006, we may redeem for cash, all or part of the Debentures at a redemption price equal to 100% of the principal amount of the Debentures, plus accrued interest up to, but not including, the date of redemption. Holders of the Debentures may require us to repurchase all or part of their Debentures on December 15, 2004, December 15, 2006, December 15, 2011 and December 15, 2016 at a price equal to 100% of the principal amount of the Debentures, plus accrued interest. We may choose to pay the purchase price in cash, shares of our common stock, or a combination of both. If we elect to pay any of the purchase price in shares, the number of shares we are required to deliver is equal to the portion of the purchase price paid in shares divided by 95% of the fair value of the shares at the time of settlement. In addition, upon a change in control of our Company occurring on or before December 15, 2021, each Debenture holder may require us to repurchase all or a portion of such holder's Debentures for cash. No Debentures were tendered for repurchase on December 15, 2004. Our scheduled debt maturities assume holders of the Debentures do not require us to repurchase all or a part of them on December 15, 2006 and also assumes that we do not redeem them for cash on or after December 15, 2006. The Debentures are convertible at the option of the holder into shares of our common stock at an initial conversion rate of 72.7272 shares of common stock per $1,000 principal amount of Debentures, which is equivalent to an initial conversion price of approximately $13.75 per share, subject to certain adjustments, in the following circumstances: (i) if the sale price of our common stock is more than 120% of the conversion price (approximately $16.50 per share) for at least 20 trading days in a 30 trading-day period prior to the date of surrender for conversion; (ii) during any period in which the credit ratings assigned to the Debentures by Moody's or Standard & Poor's are reduced to below Ba1 or BB, respectively, or in which the credit rating assigned to the Debentures is suspended or withdrawn by either rating agency; (iii)if the Debentures have been called for redemption; or (iv) upon the occurrence of specified corporate transactions. Should the Debentures meet the conversion requirements, a total of 12.7 million shares of our common stock would be issuable. The Debentures became convertible on May 1, 2003 and remained convertible through the end of fiscal 2005 (February 26, 2005) because the sale price of our common stock was more than 120% of the conversion price (approximately $16.50 per share) for at least 20 trading days in a 30 trading-day period. However, no Debenture holders opted to convert them into shares of our common stock. 4.50% SENIOR NOTES AND 5.25% SENIOR NOTES In November 2004, Holdings issued, in a private placement, $150 million principal amount of 4.50% Senior Notes due December 1, 2009, and $150 million principal amount of 5.25% Senior Notes due December 1, 2014 (collectively, the "Senior Notes"). The Senior Notes are unsecured and unsubordinated obligations of Holdings that are fully and unconditionally guaranteed by GTECH and certain of its subsidiaries. Interest is payable semi-annually in arrears on June 1 and December 1 of each year, beginning on June 1, 2005. The proceeds from the issuance of the Senior Notes will be used for general corporate purposes, which may include funding future acquisitions. In connection with the private placement, GTECH agreed to file a registration statement under the Securities Act of 1933, as amended, under which GTECH would offer to exchange the Senior Notes sold in the private placement for registered notes with otherwise identical terms. This registration statement was initially filed on January 12, 2005 and was declared effective by the Securities and Exchange Commission on April 18, 2005. In conjunction with the Senior Notes offering, in November 2004, GTECH entered into three interest rate swap contracts that effectively convert $50 million of the Senior Notes from a fixed rate to a floating rate for the period November 2004 to December 2009 and $25 million of the Senior Notes from a fixed rate to a floating rate for the period November 2004 to December 2014. GETCH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - LONG - TERM DEBT (CONTINUED) 7.87% SERIES B GUARANTEED SENIOR NOTES In May 2004, GTECH repurchased $90 million aggregate principal amount of its 7.87% Series B Guaranteed Senior Notes due May 15, 2007 (the "2007 Senior Notes") for approximately $100.6 million. The 2007 Senior Notes were unsecured and unsubordinated obligations of GTECH that were fully and unconditionally guaranteed by Holdings and certain of GTECH's subsidiaries. Interest was payable semi-annually in arrears on May 15 and November 15 of each year. In connection with this repurchase, we incurred a net charge of $0.8 million, principally comprised of a redemption premium net of deferred interest rate swap gains which we recorded in Other Income (Expense) in our Consolidated Income Statements. WORLD HEADQUARTERS LOAN Prior to February 1, 2005, we had 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. Beginning in the third quarter of fiscal 2004, we consolidated the Partnership, which required us to record the Partnership's $27.9 million loan as long-term debt (the "Loan") on our Consolidated Balance Sheet at February 28, 2004. On February 1, 2005, we repaid the Loan and acquired the remaining 50% interest in the Partnership from the general partner. CREDIT FACILITY In October 2004, GTECH entered into a $500 million unsecured revolving credit facility expiring on October 25, 2009 (the "New Credit Facility") to replace the existing $300 million Senior Credit Facility (the "Old Credit Facility") expiring on June 22, 2006. The New Credit Facility is unsecured and unsubordinated and is fully and unconditionally guaranteed by Holdings and certain of GTECH's subsidiaries. Interest is generally payable monthly in arrears at rates determined by reference to the LIBOR rate plus a margin based on GTECH Holdings Corporation's senior unsecured long-term debt rating. At February 26, 2005 and February 28, 2004 there were no outstanding borrowings under the New Credit Facility or the Old Credit Facility. At February 26, 2005, GTECH was required to pay a facility fee of .125% per annum on the total revolving credit commitment. The New Credit Facility includes a letter of credit facility of up to $100 million. At February 26, 2005, we had $7.8 million of letters of credit issued and outstanding under the New Credit Facility and $38.2 million of letters of credit issued and outstanding outside of the New Credit Facility. The total weighted average annual cost for all letters of credit was 0.84%. The credit agreement for the New Credit Facility has covenants including, among other things, requirements relating to the maintenance of certain financial ratios. There are no covenants in our New Credit Facility that restrict our ability to pay dividends. In the second quarter of fiscal 2004, we began paying annual cash dividends on our common stock of $0.34 per share and we currently plan to continue paying dividends in the foreseeable future. At February 26, 2005, we had $456 million of retained earnings available for the payment of dividends. At February 26, 2005 we were in compliance with all applicable covenants contained in our debt agreements. GETCH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - FINANCIAL INSTRUMENTS CREDIT RISK We manage our exposure to counterparty credit risk by entering into financial instruments with major, financially sound counterparties with high-grade credit ratings and by limiting exposure to any one counterparty. CASH AND CASH EQUIVALENTS Cash equivalents are stated at cost, which approximates fair value. INVESTMENT SECURITIES AVAILABLE-FOR-SALE The carrying amounts and estimated fair values of our investment securities are as follows:
February 26, 2005 February 28, 2004 -------------------- -------------------- Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value -------- --------- -------- --------- (Dollars in thousands) State and Municipal Auction Rate Securities $196,825 $ 196,825 $116,450 $ 116,450 State and Municipal Variable Rate Demand Obligations -- -- 77,900 77,900 Corporate Auction Rate Preferred Securities -- -- 27,500 27,500 -------- --------- -------- --------- $196,825 $ 196,825 $221,850 $ 221,850 ======== ========= ======== =========
LONG-TERM DEBT The carrying amounts and estimated fair values of our debt, as determined by an independent investment banker, are as follows:
February 26, 2005 February 28, 2004 -------------------- -------------------- Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value -------- --------- -------- --------- (Dollars in thousands) 4.75% Senior Notes due October 2010 $249,690 $ 248,565 $249,636 $ 255,960 1.75% Convertible Debentures due December 2021 175,000 304,500 175,000 375,156 4.50% Senior Notes due December 2009 149,604 148,620 -- -- 5.25% Senior Notes due December 2014 148,704 149,238 -- -- Fair value of interest rate swaps 541 541 4,893 4,893 7.87% Series B Guaranteed Senior Notes due May 2007 -- -- 90,000 99,976 World Headquarters loan due January 2007 -- -- 27,933 27,933 Deferred interest rate swap gains -- -- 12,009 12,009 Other, due through October 2007 5,266 5,266 10,063 10,063 -------- --------- -------- --------- $728,805 $ 856,730 $569,534 $ 785,990 ======== ========= ======== =========
GETCH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - FINANCIAL INSTRUMENTS (CONTINUED) FOREIGN CURRENCY EXCHANGE CONTRACTS The following table summarizes, by major currency, the contractual amounts of our forward exchange and option contracts translated to United States dollars using the exchange rate at the balance sheet date. The buy and sell amounts represent the United States dollar equivalent of commitments to purchase and sell foreign currencies.
February 26, 2005 February 28, 2004 --------------------- --------------------- Buy Sell Buy Sell Contracts Contracts Contracts Contracts --------- --------- --------- --------- (Dollars in thousands) Brazilian real $ 10,100 $ -- $ 10,100 $ -- Pounds sterling 7,643 11,618 8,412 20,949 Taiwan dollar 7,010 -- 6,242 -- Canadian dollar 6,491 -- -- -- Euro 6,195 24,876 642 26,329 Mexican peso 3,929 -- 5,375 -- Swedish krona 3,705 1,250 7,400 -- Australian dollar 620 -- 780 2,011 Czech koruna -- 3,108 -- 6,957 Other 707 8,106 6,369 7,588 --------- --------- --------- --------- TOTAL $ 46,400 $ 48,958 $ 45,320 $ 63,834 ========= ========= ========= =========
The fair values of our foreign currency exchange contracts are estimated based on quoted market prices of comparable contracts, adjusted through interpolation when necessary for maturity differences. The carrying amounts and estimated fair values of our foreign currency exchange contracts, which are recorded in Accounts Payable in our consolidated financial statements, are as follows:
February 26, 2005 February 28, 2004 -------------------- -------------------- Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value -------- --------- -------- --------- (Dollars in thousands) Foreign currency exchange contracts $ 599 $ 599 $ 1,528 $ 1,528 ======== ========= ======== =========
GETCH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - FINANCIAL INSTRUMENTS (CONTINUED) INTEREST RATE SWAPS Interest rate swaps outstanding and the related debt instruments are as follows:
February 26, 2005 February 28, 2004 ------------------------ ------------------------ Debt Interest Rate Debt Interest Rate Carrying Swaps Carrying Swaps Value Outstanding Value Outstanding -------- ------------- -------- ------------- (Dollars in thousands) 4.75% Senior Notes due October 2010 $249,690 $ 150,000 $249,636 $ 150,000 4.50% Senior Notes due December 2009 149,604 50,000 -- -- 5.25% Senior Notes due December 2014 148,704 25,000 -- --
These interest rate swaps exchange fixed interest rates for variable interest rates through the due date of the related debt instrument. The fair value of the interest rate swaps were recorded as assets and the carrying value of the underlying debt was adjusted by an equal amount in accordance with SFAS 133. During the third quarter of fiscal 2003, we sold $135 million notional amount of interest rate swaps for $13.1 million. Approximately $10.0 million of those proceeds were being amortized as a reduction of interest expense through the due date of the 2007 Senior Notes. During the first quarter of fiscal 2005, in connection with the repurchase of the $90 million of 2007 Senior Notes, we recorded a net charge of $0.8 million, principally comprised of a redemption premium net of deferred interest rate swap gains, which we recorded in Other Income (Expense) in our Consolidated Income Statements. TREASURY RATE LOCK AGREEMENTS During the third quarter of fiscal 2005, we entered into agreements to lock in interest rates to hedge against potential increases to interest rates prior to the issuance of our Senior Notes due December 2009 and December 2014. We determined that the treasury rate lock agreements were highly effective and qualified for hedge accounting. All treasury rate lock agreements have matured. The related gains of $2.0 million were deferred and recorded in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheet at February 26, 2005 and are being amortized to interest expense over the life of the respective debt instruments. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES CONTRACTS Our contracts generally contain time schedules for, among other things, commencement of system operations and the installation of terminals, as well as detailed performance standards. We are typically required to furnish substantial bonds to secure our performance under contracts. In addition to other possible consequences, including contract termination, failure to meet specified deadlines or performance standards could trigger substantial penalties in the form of liquidated damage assessments. Many of our contracts permit the customer to terminate the contract at will and do not specify the compensation, if any, that we would be entitled to, were such a termination to occur. In fiscal 2005, 2004 and 2003, we paid or incurred liquidated damages (with respect to our contracts) of $2.3 million, $5.2 million and $4.6 million, respectively. ACQUISITION In December 2004, we entered into an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") owned by the owners of the privately-held Gauselmann Group ("Gauselmann"). The remaining 50% of Atronic will be retained by the owners of Gauselmann. Atronic is a video slot machine manufacturer and also develops slot machine games and customized solutions for dynamic gaming operations. The final purchase price for Atronic will be calculated through a performance-based formula equal to eight times Atronic's EBITDA (earnings before interest, taxes, depreciation and amortization) for its fiscal year ending December 31, 2006. In addition, in the 12 months after the closing, Atronic will also have the potential to receive an earn-out amount based on its 2007 performance above specified thresholds. We currently expect the all-cash transaction will have a total value of approximately $100 million to $150 million, for our 50% share, including the assumption of debt. Beginning in 2012, we have the option to purchase Gauselmann's interest in Atronic and Gauselmann has a reciprocal right to sell its interest to us at a value determined by independent appraisers. There are also mutual put/call rights that may become effective before 2012, under certain circumstances. The exercise price under these circumstances will be calculated through a performance based formula. This transaction is contingent upon regulatory and gaming license approvals and other closing conditions, and is expected to be completed on December 31, 2006. On March 24, 2005 (after the close of fiscal 2005), we guaranteed 50% of Atronic's obligations due under a Euro 50 million (approximately $65 million at the April 20, 2005 exchange rate) loan made by an unrelated commercial lender to Atronic (the "Agreement"). Our maximum liability under this guaranty is equal to the lesser of Euro 25 million (approximately $33 million at the April 20, 2005 exchange rate) or 50% of Atronic's outstanding obligations under the Agreement. The guarantee arose in connection with our planned acquisition of Atronic on December 31, 2006. We would be required to perform under the guaranty should Atronic fail to make any interest or principal payments in accordance with the terms and conditions of the Agreement. Our guarantee expires on April 26, 2010. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) LITIGATION BRAZILIAN LEGAL PROCEEDINGS THE CEF CONTRACT PROCEEDINGS BACKGROUND. In January 1997, Caixa Economica Federal ("CEF"), the Brazilian bank and operator of Brazil's National Lottery, and Racimec Information Brasileira S.A. ("Racimec"), the predecessor of the Company's subsidiary GTECH Brasil Ltda. ("GTECH Brazil"), entered into a four-year contract pursuant to which GTECH Brazil agreed to provide online lottery services and technology to CEF (the "1997 Contract"). In May 2000, CEF and GTECH Brazil terminated the 1997 Contract and entered into a new agreement (the "2000 Contract") obliging GTECH Brazil to provide lottery goods and services and additional financial transaction services to CEF for a contract term that, as subsequently extended, was scheduled to expire in April 2003. In April 2003, GTECH Brazil entered into an agreement with CEF (the "2003 Contract Extension") pursuant to which: (a) the term of the 2000 Contract was extended into May 2005, and (b) fees payable to GTECH Brazil under the 2000 Contract were reduced by 15%. CEF recently completed a procurement process for products and services to replace those that we currently provide under the 2000 Contract. Based upon the commodity auction nature of the procurement process and the revenue restrictions that were then imposed on us by the courts, we elected not to participate in the bid process. CEF has also announced that it is developing its central system in-house. As provided in the 2000 Contract, CEF may elect to extend the 2000 Contract for one year beyond its scheduled May 2005 termination date on its existing terms and conditions. In addition, we are currently involved in negotiations with CEF respecting the possible extension of the term of the 2000 Contract for the provision of goods and services by us after the scheduled termination date of the 2000 Contract. There can be no assurance that CEF will elect to extend the 2000 Contract for an additional year on its existing terms and conditions, or that CEF and GTECH Brazil will reach agreement to extend the term of the 2000 Contract on other terms. Revenues from the 2000 Contract accounted for approximately 7.2% of our total revenues for fiscal 2005, making CEF our second largest customer in fiscal 2005 based on revenues. CRIMINAL ALLEGATIONS AGAINST CERTAIN EMPLOYEES AND RELATED SEC INVESTIGATION. As previously reported, in late March 2004 federal attorneys with Brazil's Public Ministry (the "Public Ministry Attorneys") recommended that criminal charges be brought against nine individuals, including four senior officers of CEF, Antonio Carlos Rocha, the former Senior Vice President of Holdings and President of GTECH Brazil; and Marcelo Rovai, GTECH Brazil's marketing director. The Public Ministry Attorneys had recommended that Messrs. Rocha and Rovai be charged with offering an improper inducement in connection with the negotiation of the 2003 Contract Extension, and co-authoring, or aiding and abetting, certain allegedly fraudulent or inappropriate management practices of the CEF management who agreed to enter into the 2003 Contract Extension. No other present or former employee of the Company or GTECH Brazil has been implicated by the Public Ministry Attorneys. Neither the Company nor GTECH Brazil is the subject of this criminal investigation, and under Brazilian law (which provides that criminal charges may not be brought against corporations or other entities), we cannot be subject to criminal charges in connection with this matter. As previously reported, during the second quarter of fiscal 2005, the judge reviewing these charges prior to their being filed refused to initiate the criminal charges against the nine individuals, including against Messrs. Rocha and Rovai, but instead granted a request by the Brazilian Federal Police to continue the investigation which had been suspended upon the recommendation of the Public Ministry Attorneys that criminal charges be brought. The Brazilian Federal Police subsequently ended their investigation and presented a final report of their findings to the court. This final report does not recommend that indictments be issued against Messrs. Rocha or Rovai, or against any current or former employee of the Company. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) As previously reported, we cooperated fully with the investigation by Brazilian authorities respecting this matter, and encouraged Messrs. Rocha and Rovai to do the same. In addition, as previously reported, we conducted an internal investigation of the 2003 Contract Extension under the supervision of the independent directors of GTECH Holdings Corporation. Our investigation did not reveal any reason to believe that any of our present or former employees had committed any of the criminal offenses alleged by the Public Ministry Attorneys. Notwithstanding the favorable resolution of the Brazilian Federal Police investigation and the favorable results of our own internal investigation respecting the 2003 Contract Extension, there can be no assurance that (a) the Public Ministry Attorneys will not once again recommend to the judge hearing this case that such criminal charges be initiated against Messrs. Rocha and Rovai, (b) the Brazilian Federal Police will not broaden their investigation to include the award of, and performance under, the 1997 Contract and 2000 Contract, or (c) new criminal charges will not be initiated against Messrs. Rocha and Rovai or additional individuals. As previously reported, the United States Securities and Exchange Commission (the "SEC") is undertaking a formal investigation into the Brazilian criminal allegations against Messrs. Rocha and Rovai and the Company's involvement in this matter. The Company has been cooperating fully with the SEC. To date we have found no evidence that the Company, or any of its employees, has violated any United States law, or is otherwise guilty of any wrongdoing in connection with this matter. In light of the fact that our reputation for integrity is an important factor in our business dealings with lottery and other governmental agencies, an allegation or finding of improper conduct that is attributable to us could have a material adverse effect on our business, both within Brazil and elsewhere, including our ability to retain existing contracts or to obtain new or renewal contracts. CIVIL ACTION BY THE PUBLIC MINISTRY ATTORNEYS. As previously reported, in April 2004 the Public Ministry Attorneys initiated a civil action in the Federal Court of Brasilia against GTECH Brazil; 17 former officers and employees of CEF; the former president of Racimec; Antonio Carlos Rocha; and Marcos Andrade, another former officer of GTECH Brazil. The focus of this civil action is the contractual relationship between CEF, GTECH Brazil and Racimec during the period 1994 to 2002. This civil action alleges that the defendants acted illegally in entering into, amending and performing, the 1997 Contract, and the 2000 Contract, and seeks to invalidate the 2000 Contract, which, as extended by the 2003 Contract Extension, is still in force. As previously reported, this lawsuit also seeks to impose damages equal to the sum of all amounts paid to the Company under the 1997 Contract and the 2000 Contract, and certain other permitted amounts, minus our proven investment costs. The applicable statute also permits the assessment of penalties, in the discretion of the court, of up to three times the amount of the damages imposed. We estimate that through the date of the lawsuit we received under the 1997 Contract and the 2000 Contract a total of 1.5 billion Brazilian reals (or approximately 500 million United States dollars). In addition, although it is unclear how investment costs would be determined for purposes of this lawsuit, we estimate that our investment costs through the date of the lawsuit were approximately between 1.2 billion and 1.4 billion Brazilian reals (or approximately between 400 million and 465 million United States dollars) in aggregate; however, these investment costs could be disputed by CEF, and are ultimately subject to approval by the court. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) As previously reported, we believe we have good and adequate defenses to the claims made in this lawsuit. We intend to defend ourselves vigorously in these proceedings, which, we have been advised by our Brazilian counsel, are likely to take several years, and could take as long as 10 to 15 years in certain circumstances, to litigate through the appellate process to final judgment. It is our position that we were appropriately awarded the 1997 Contract by CEF after a competitive procurement, and that at all times since 1997 we have been appropriately compensated for services performed under valid contracts with the CEF. While we cannot rule out the possibility that the Company will ultimately be held liable in this matter, or estimate the amount of such liability in such event, we believe that the outcome of this lawsuit is not likely to have a material impact on our financial statements or business. As previously reported, in June 2004, the Federal Court of Brasilia granted a procedural injunction in connection with this civil matter which ordered that 30% of payments made subsequent to the date of the injunction to GTECH Brazil by CEF under the 2000 Contract be withheld and deposited into an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited into an account pursuant to this ruling was approximately 68 million Brazilian reals, or 26 million United States dollars. This injunction also put in place restrictions that effectively prevented the transfer or sale of the Company's Brazilian assets, including the share capital of GTECH Brazil, with certain limited exceptions. The injunction was granted as part of a confidential ex parte proceeding in which we were not afforded an opportunity to participate. We filed an appeal respecting the court's grant of this injunction in July 2004. On March 22, 2005, a panel of judges of the Brazilian Federal Court of Appeals heard our appeal of the procedural injunction granted by the Federal Court of Brasilia and issued an order: (a) discontinuing the withholding of payments due to GTECH Brazil from CEF that had been mandated by the procedural injunction, (b) removing the procedural injunction's restrictions on the transfer or sale of the Company's Brazilian assets, and (c) requiring the return to GTECH Brazil of amounts in excess of 40 million Brazilian reals held in escrow pursuant to the procedural injunction, thereby permitting the return to GTECH of approximately 11 million United States dollars of the 26 million United States dollars held in escrow as of the end of fiscal 2005. The appeals court also ordered that 40 million Brazilian reals continue to be held in escrow, and that the procedural injunction's requirements that defendants report assets to the court, and that the Brazilian Central Bank report any transaction associated with these assets, be maintained. This order of the Brazilian Federal Court of Appeals may be appealed by the Brazilian Public Attorneys. POPULAR CLAIM. As previously reported, in February 2004, Vincius Bijos, a Brazilian, commenced a public class action lawsuit in Brazil's Brasilia District Court of the Federal District against the Brazilian Federal government; CEF; several former and current officers of CEF; the former president of Racimec; and GTECH Brazil, seeking, among the relief requested of the Court, a preliminary injunction prohibiting CEF from making further payments to GTECH Brazil under the 2000 Contract, and an order that would terminate the 2000 Contract and require the defendants, jointly and severally, to refund amounts received by GTECH Brazil under the 1997 Contract and the 2000 Contract, together with interest, appropriate monetary adjustments, court costs and expenses. This public class action lawsuit bases its claims upon numerous alleged defects and irregularities, which the suit asserts violate Brazilian law, in the 1997 Contract and the 2000 Contract, and the manner in which the procurement processes that gave rise to the awards of these contracts were organized and administered. We intend to mount a vigorous challenge to the far-reaching claims that make up this lawsuit. We note that the Public Ministry Attorneys have filed an opinion with the federal court disagreeing with the request that an injunction enjoining payments from CEF to GTECH Brazil be entered and requesting that this suit be consolidated with the Public Ministry Attorneys' civil action described above. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) While we cannot rule out the possibility that the Company will ultimately be held liable in this matter, or estimate the amount of such liability in such event, we believe that the outcome of this lawsuit is not likely to have a material impact on our financial statements or business. TCU AUDIT. As previously reported, in June 2003, the Federal Court of Accounts ("TCU"), the court charged with auditing agencies of the Brazilian federal government and its subdivisions, summoned us, together with several current and former employees of the CEF to appear before TCU's Brasilia court. The summons required the defendants to show cause why they should not be required to jointly pay a base amount determined on a preliminary basis by the TCU to be due of R$91,974,625, duly indexed for inflation and interest as of May 26, 2000 (Decision No. 692/2003). We estimate that this claim, in aggregate, is for the local currency equivalent of approximately 87.6 million United States dollars at exchange rates in effect as of February 26, 2005. The allegations underlying this summons are set forth in a report (the "Audit Report") issued by the TCU in May 2003 respecting an audit conducted by the TCU of the 1997 Contract. The central allegation of the Audit Report is that under the 1997 Contract we were accorded certain payment increases, and we contracted to supply to CEF certain services, that were not contemplated by the procurement process respecting the 1997 Contract and that are not otherwise permitted under applicable Brazilian law. The Audit Report alleges that as a result of this, CEF overpaid us under the 1997 Contract for the period commencing in January 1997 through May 26, 2000, and that we are liable with respect to such alleged overpayments as specified above. The Audit Report states that the TCU will refer the Audit Report to, among others, the Public Ministry Attorneys and the Brazil Federal Police (who, we have been advised, are conducting an investigation of CEF's public procurement activities in general). See - "Criminal Allegations Against Certain Employees and Related SEC Investigation" and "Civil Action by Public Ministry Attorneys," above. The Audit Report does not allege that we have acted improperly. In November 2003, we presented our defense to the claims and preliminary determination of the TCU that CEF had overpaid us. In light of our defense, in September 2004, the TCU reduced its determination of the amount alleged to have been overpaid to us by CEF under the 1997 Contract from R$91,974,625 to R$30,317,721, or approximately 28.9 million United States dollars at exchange rates in effect as of February 26, 2005. This determination by the TCU remains subject to approval by TCU's judges. We plan to continue to vigorously defend ourselves against the allegations made by TCU in the Audit Report and the proceedings initiated by the TCU with respect thereto. We believe that we have good defenses to the claims and determinations of the TCU. We further believe that the claims and determinations of the Audit Report have, in essence, been merged into the civil action instituted by the Public Ministry Attorneys described above, and are accordingly unlikely to represent an independent potential source of liability for us. While we are unable to rule out the possibility that the Company will ultimately be held liable in this matter, we believe that the outcome of this matter is not likely to have a material impact on our financial statements or business. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) SERLOPAR SUIT As previously reported, in April 2002 Serlopar, the lottery authority for the Brazilian state of Parana, sued our subsidiaries Dreamport Brasil Ltda. and GTECH Brazil in the 2nd Public Finance Court of the City of Curitiba, State of Parana, under an agreement dated July 31, 1997, as amended (the "VLT Agreement"). Pursuant to the VLT Agreement, we agreed to install and operate video lottery terminals ("VLTs") in Parana. Serlopar alleges in its suit that we installed only 450 of the 1,000 VLTs that we were allegedly obliged to install, and that we were overpaid, and failed to reimburse Serlopar certain amounts alleged to be due to Serlopar, under the VLT Agreement. Serlopar seeks payment from us of approximately 40 million United States dollars (at exchange rates in effect on February 26, 2005) with respect to these claims, together with unspecified amounts alleged to be due from the defendants with respect to general losses and damages (including loss of revenues) and court costs and legal fees. We believe we have good defenses to the claims made by Serlopar in this lawsuit, and we intend to continue to defend ourselves vigorously in these proceedings. We believe that the outcome of this suit will not have a material impact on our financial statements or business. OTHER LEGAL PROCEEDINGS ARGENTINA MONEY TRANSFER MATTER In February 2005, GTECH Foreign Holdings Corporation, Argentina Branch ("GFHC") and our Argentina legal counsel, Dr. Jorge Perez of Perez, del Barba and Rosenblum, received notification from the Central Bank of Argentina that they were being indicted for alleged violations of Argentina's currency exchange laws. The Argentina laws in question prohibit the transfer of foreign currency from Argentina, subject to certain exceptions not here relevant. At issue is a February 2002 agreement (the "BofA Agreement") between GFHC and Bank of America, N.A., Buenos Aires Branch ("BofA") pursuant to which BofA assigned to GFHC a certificate of deposit in the amount of 571,429 United States dollars (the "CD"), issued by Bank of America, Charlotte, North Carolina Branch ("BofA-North Carolina"), in consideration for the payment of 1.4 million Argentina pesos. Upon maturity of the CD, the agreement provided for BofA-North Carolina to pay 571,429 United States dollars to a GFHC branch bank account in the United States. We understand that the central claim of the Argentina Central Bank's indictment will be that GFHC's agreement with BofA was a transaction in which foreign currency was transferred, in essence, from Argentina to the United States in violation of applicable Argentina law. If GFHC is found guilty of violating applicable Argentina currency exchange laws, as charged in the indictment, we would be liable to pay a fine of up to approximately 5.7 million United States dollars (i.e., ten times the amount of United States dollars allegedly transferred from Argentina) and could be prohibited for up to ten years from importing goods into, or exporting goods from, Argentina. We note that BofA, which solicited GTECH to enter into the BofA Agreement, and approximately 20 other customers of BofA including several subsidiaries of large multi-national corporations, have been indicted in connection with transactions similar to the transaction outlined in the BofA Agreement. BofA explicitly represented to us in the BofA Agreement that the transaction described therein did not violate any Argentina law or regulation, and we believe that we took appropriate measures independent of this representation (including obtaining the opinion of local counsel) in advance of entering into the BofA Agreement to ascertain that this transaction was legal under applicable Argentina law. We believe that we have good defenses to the claims made on the indictment, and we intend to vigorously defend ourselves in these proceedings. We do not believe that the outcome of this suit will have a material impact on our financial statements or business. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES (CONTINUED) COHEN SUIT As previously reported, on August 7, 2002 we terminated without cause the employment of Howard S. Cohen, our former President and Chief Executive Officer. In March 2003, Mr. Cohen attempted to exercise options granted by us in April 2002 to purchase (on a pre-split adjusted basis) 450,000 shares of our Common Stock at a per-share exercise price of $23.30. The non-qualified stock option agreement entered into between Mr. Cohen and us respecting the April 2002 grant of options provides by its terms that, in the event that Mr. Cohen's employment was terminated without cause, options remaining exercisable must be exercised within six months from the date of termination (i.e., by February 7, 2003). Because Mr. Cohen had failed to exercise his April 2002 options within the term provided in the applicable stock option agreement, we did not permit Mr. Cohen to exercise these options. In May 2003, Mr. Cohen filed suit in Rhode Island Superior Court against us and the attorneys who had advised him in connection with the negotiation of his severance agreement, respecting his attempt to exercise the April 2002 stock options. The suit, captioned Howard S. Cohen v. GTECH Corporation, GTECH Holdings Corporation, Michael J. Tuchman, Levenfeld Pearlstein, Charlene F. Marant and Marant Enterprises Holdings LLC, alleges that: (i) we breached our agreements with Mr. Cohen in failing to allow him to exercise his April 2002 options; (ii) through fraud by us, or the mutual mistake of the parties, the April 2002 option grant does not reflect the intent of the parties, and (iii) we had a duty to advise Mr. Cohen of his mistaken belief (if such it was) as to the exercise term of the April 2002 options, and failed to so advise Mr. Cohen. Mr. Cohen also alleges that his attorneys had failed in their duty of care in misadvising him as to the correct period during which he could exercise his options, and, in addition, had practiced law in Rhode Island without a license in violation of applicable Rhode Island law. Mr. Cohen seeks damages against us and the other defendants in an amount of not less than 4.0 million United States dollars, plus interest, costs and reasonable attorneys fees. With respect to us, he also seeks an order reforming the terms of the April 2002 option grant to reflect the alleged intent of the parties with respect to the post-termination exercise term, and other equitable relief. Mr. Cohen also asks for a declaratory judgment construing our 2000 Omnibus Stock Option and Long Term Incentive Plan and Mr. Cohen's employment and severance agreements, as to the relevant option exercise period. We believe that we have good defenses to the claims made by Mr. Cohen in this lawsuit and we intend to vigorously defend ourselves in these proceedings. Nevertheless, at the present time we are unable to predict the outcome of this lawsuit. We also are subject to certain other legal proceedings and claims which management believes, on the basis of information presently available to it, will not materially adversely affect our consolidated financial position or results of operations. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15 - 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 certain specified events 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 they will do so. The following table provides information related to potential commitments at February 26, 2005:
Total potential commitments --------------- (in thousands) Performance bonds $ 208,144 Litigation bonds 6,782 All other bonds 4,302 --------------- $ 219,228 ===============
LOTTERY TECHNOLOGY SERVICES INVESTMENT CORPORATION We have a 44% interest in Lottery Technology Services Investment Corporation (the "Holding Company"), which we account for using the equity method of accounting. The Holding Company's wholly owned subsidiary, Lottery Technology Services Corporation (the "Subsidiary"), provides equipment and services (which we supplied to the Subsidiary), to the Bank of Taipei. The Bank of Taipei holds the license to operate the Taiwan Public Welfare Lottery (the "Lottery"). On November 29, 2004, the Holding Company merged with the Subsidiary and the Subsidiary is the surviving company (the merged company is collectively referred to as "LTSC"). (See Note 23.) In fiscal 2002, in order to assist LTSC with the financing they required to enable them to perform under their obligation to operate the Lottery, we guaranteed loans made to LTSC by an unrelated commercial lender. 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. At February 28, 2004, the principal amount of loans that we guaranteed totaled $4.6 million. LTSC repaid all borrowings under the guaranteed loans in September 2004 and our guarantee expired in October 2004. We recognize 56% of gross profit on product sales to LTSC and defer the remaining 44% as a result of our equity interest in LTSC. We recognize these deferrals ratably over the life of our contract with LTSC. At February 26, 2005 and February 28, 2004, deferred product gross profit totaling $2.0 million and $3.4 million, respectively, is included in Deferred Revenue and Advance Billings and Other Liabilities in our Consolidated Balance Sheets. In fiscal 2002, we signed an agreement with Acer, Inc. ("Acer"), the partner that holds the remaining 56% interest in LTSC, which provides that in the event a third party lender to LTSC requires the guarantee of GTECH or Acer as a condition of making a loan to LTSC, we, along with Acer, will provide such a guarantee on reasonable terms. This potential guarantee is limited to 44% of any such third-party loan and would expire on December 31, 2006. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15 - GUARANTEES AND INDEMNIFICATIONS (CONTINUED) 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. ("DELTA"). 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 may be jointly and severally liable, with DELTA, for the obligations of the joint venture. TIMES SQUARED INCORPORATED In December 1998, we guaranteed outstanding lease obligations of Times Squared Incorporated ("Times Squared") for which we received no monetary consideration. Our guarantee terminated in December 2004. The amount outstanding under the lease at February 28, 2004 was $2.3 million. 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. DELAWARE LLC At February 28, 2004, we held a 50% interest in Gaming Entertainment (Delaware) L.L.C. ("GED"). GED is also owned 50% by a subsidiary of Full House Resorts, Inc. ("FHRI"). Pursuant to a 1995 management agreement ("Agreement"), GED manages a racino 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 guaranteed the payment of all amounts due Harrington under the Agreement. The consideration we received in exchange for the guarantee was the equity earnings from our ownership in GED. During the first quarter of fiscal 2005, we sold our 50% interest in GED to Harrington for $11.8 million and recognized a gain of $10.9 million which was recorded in Other Income (Expense) in our Consolidated Income Statements. Our guarantee expired upon the sale of our 50% interest. ATRONIC In December 2004, we entered into an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") owned by the owners of the privately-held Gauselmann Group ("Gauselmann"). The remaining 50% of Atronic will be retained by the owners of Gauselmann. Atronic is a video slot machine manufacturer and also develops slot machine games and customized solutions for dynamic gaming operations. This transaction is contingent upon regulatory and gaming license approvals and other closing conditions, and is expected to be completed on December 31, 2006. On March 24, 2005 (after the close of fiscal 2005), we guaranteed 50% of Atronic's obligations due under a Euro 50 million (approximately $65 million at the April 20, 2005 exchange rate) loan made by an unrelated commercial lender to Atronic (the "Agreement"). Our maximum liability under this guaranty is equal to the lesser of Euro 25 million (approximately $33 million at the April 20, 2005 exchange rate) or 50% of Atronic's outstanding obligations under the Agreement. The guarantee arose in connection with our planned acquisition of Atronic on December 31, 2006. We would be required to perform under the guaranty should Atronic fail to make any interest or principal payments in accordance with the terms and conditions of the Agreement. Our guarantee expires on April 26, 2010. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15 - GUARANTEES AND INDEMNIFICATIONS (CONTINUED) LOXLEY GTECH PRIVATE LIMITED We have a 49% interest in Loxley GTECH Private Limited Co. ("LGT"), which is accounted for using the equity method of accounting. LGT is a corporate joint venture that is expected to provide the online lottery system in Thailand. On March 29, 2005 (after the close of fiscal 2005), in order to assist LGT with obtaining the financing they require to enable them to perform under their anticipated obligation to operate the online lottery system in Thailand, we guaranteed, along with the other 51% shareholder in LGT, Baht 1.925 billion (approximately $49 million at the April 20, 2005 exchange rate) principal amount in loans and Baht 455 million (approximately $12 million at the April 20, 2005 exchange rate) in performance bonds and trade finance facilities made to LGT by an unrelated commercial lender (collectively the "Facilities"). We are jointly and severally liable with the other shareholder in LGT for this guarantee. We would be required to perform under the guaranty should LGT fail to make interest or principal payments in accordance with the terms and conditions of the Facilities. Our guarantee obligations will not commence until LGT enters into a definitive agreement with the government, which we currently expect will take place in the second quarter of fiscal 2006, and will terminate upon the start-up of the online lottery system in Thailand, which is currently expected to occur in the fourth quarter of fiscal 2006. WORLD HEADQUARTERS FACILITY Under our Master Contract with the State of Rhode Island, we are to invest (or cause to be invested) at least $100 million in the State of Rhode Island, in the aggregate, by December 31, 2008. This investment commitment includes the development of a new world headquarters facility in Providence, Rhode Island by December 31, 2006. We have entered into (i) a development agreement with US Real Estate Limited Partnership (the "Developer"), whereby the Developer will develop and own the facility; and (ii) an office lease with the Developer, whereby we will lease a portion of the facility from the Developer for 20 years. We also entered into (i) a 149 year ground lease with Capital Properties, Inc. (the "Ground Landlord") with respect to the land upon which the facility will be constructed; and (ii) a completion guarantee in favor of the Ground Landlord whereby we guaranteed the completion of the facility and the payment of the rent and real estate taxes under the ground lease until the completion of the facility. We have assigned the ground lease to the Developer but remain liable under the ground lease and the completion guarantee. Rent payable under the ground lease is currently $0.1 million per year. It is our position that our liability under the ground lease will expire upon completion of the facility. Upon completion of the facility, the Ground Landlord's recourse in the event of a default by the Developer under the ground lease is limited to the facility. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16 - ACCUMULATED OTHER COMPREHENSIVE LOSS The components of, and changes in, other comprehensive loss are as follows:
Foreign Net Gain (Loss) Unrealized Treasury Currency on Derivative Gain (Loss) Rate Translation Instruments on Investments Lock Total ----------- --------------- -------------- -------- --------- (Dollars in thousands) Balance at February 23, 2002 $ (101,039) $ 174 $ 50 $ -- $(100,815) Changes during the year, net of tax 5,344 91 (108) -- 5,327 ----------- --------------- -------------- -------- --------- Balance at February 22, 2003 (95,695) 265 (58) -- (95,488) Changes during the year, net of tax 26,418 (1,423) (15) -- 24,980 ----------- --------------- -------------- -------- --------- Balance at February 28, 2004 (69,277) (1,158) (73) -- (70,508) Changes during the year, net of tax 24,618 677 (2) 1,988 27,281 ----------- --------------- -------------- -------- --------- Balance at February 26, 2005 $ (44,659) $ (481) $ (75) $ 1,988 $ (43,227) =========== =============== ============== ======== =========
FOREIGN CURRENCY TRANSLATION Our current contract with Caixa Economica Federal ("CEF"), the operator of Brazil's National Lottery and our second largest customer in fiscal 2005 based on annual revenues, is scheduled to expire in May 2005. We are currently involved in negotiations with CEF respecting the possible extension of the term of our current contract with CEF for the provision of goods and services by us after the scheduled termination date of our current contract. Foreign currency translation related to our operations in Brazil of $59.5 million (which is included in the $44.7 million at February 26, 2005 above), would be recorded as a charge to our consolidated income statement upon the expiration of our contract with CEF should we determine that the expiration of the CEF contract results in a substantial liquidation of our investment in Brazil. Refer to Note 14 for detailed disclosures regarding Brazilian legal proceedings. NET GAIN (LOSS) ON DERIVATIVE INSTRUMENTS The $0.5 million of net losses on derivative instruments at February 26, 2005 is expected to be reclassified to earnings within the next 12 months as the underlying transactions occur. TREASURY RATE LOCK The treasury rate lock of $2.0 million at February 26, 2005 represents the net amount of deferred gains we realized related to our agreements to lock in interest rates to hedge our 4.5% Senior Notes due December 2009 and our 5.25% Senior Notes due December 2014, against potential increases to interest rates prior to their issuance. The deferred gains are being amortized to interest expense over the life of the respective debt instrument. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17 - CONSOLIDATION OF VARIABLE INTEREST ENTITIES In December 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities" ("FIN 46"). We were required to apply FIN 46 in our consolidated financial statements for periods ending after December 15, 2003 (our fiscal 2004 fourth quarter) for interests in variable interest entities that were considered to be special-purpose entities and for periods ending after March 15, 2004 (our fiscal 2005 first quarter) for all other types of variable interest entities. Earlier application was permitted. FIN 46 addresses the consolidation of entities to which the usual condition of consolidation does not apply (ownership of a majority voting interest) and focuses on controlling financial interests that may be achieved through arrangements that do not involve voting interests. FIN 46 concludes that in the absence of clear control through voting interests, a company's exposure (variable interest) to the economic risks and potential rewards from the variable interest entity's assets and activities are the best evidence of control. If an enterprise holds a majority of the variable interests of an entity, it would be considered the primary beneficiary. Upon consolidation, the primary beneficiary is generally required to include assets, liabilities and noncontrolling interests at fair value and subsequently account for the variable interest as if it were consolidated based on majority voting interest. We determined that we are the primary beneficiary of the following variable interest entities and have consolidated these entities in accordance with FIN 46. WEST GREENWICH TECHNOLOGY ASSOCIATES, L.P. Prior to February 1, 2005, we had 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 was an unrelated third party. Prior to the third quarter of fiscal 2004, we accounted for the Partnership using the equity method of accounting. Beginning in the third quarter of fiscal 2004, we consolidated the Partnership in accordance with FIN 46 and as a result, we recorded our world headquarters facilities owned by the Partnership as an asset and the Partnership's loan as a liability in our consolidated financial statements. The consolidation of the Partnership increased balance sheet assets and liabilities by $30.0 million and $26.7 million, respectively, and resulted in a one-time, non-cash, after-tax gain of $3.3 million. The pre-tax gain of $5.3 million is recorded in Other Income (Expense) in our Consolidated Income Statements and not as a cumulative-effect adjustment because the gain is not material to our consolidated financial statements. On February 1, 2005, we repaid the Partnership's loan and acquired the remaining 50% interest in the Partnership from the general partner. AITKEN SPENCE GTECH PRIVATE LIMITED We have a 50% interest in Aitken Spence GTECH Private Limited ("ASG"), a corporate joint venture that aids in the operation and management of the lottery in Sri Lanka. The other partner is an unrelated third party. In accordance with FIN 46, we consolidated ASG in the fourth quarter of fiscal 2005 which increased balance sheet assets and liabilities by $7.7 million and $5.1M, respectively. Our Company's investment in ASG (including loans) totaled approximately $4.0 million at February 26, 2005, representing our maximum exposure to loss. Any creditors of ASG do not have recourse against the general credit of the Company as a result of including ASG in our consolidated financial statements. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18 - STOCK-BASED COMPENSATION PLANS We have various stock-based compensation plans whereby nonemployee members of our Board of Directors, officers and other key employees may receive grants of incentive stock options, nonqualified stock options, restricted stock, stock appreciation rights and performance awards. We are authorized to grant up to 27,200,000 shares of common stock under these plans. The stock options granted under these plans are to purchase our common stock at a price not less than fair market value at the date of grant. Stock options generally vest ratably over a four-year period from the date of grant and expire 10 years after the date of grant (unless an earlier expiration date is set at the time of grant) and are subject to possible earlier exercise and termination in certain circumstances. Beginning in fiscal 2005, stock options for Senior Staff Officers of our Company generally vest ratably over a four-year period beginning on the second anniversary date of the grant. Beginning in fiscal 2006, all stock options will generally vest ratably over a four-year period beginning on the second anniversary date of the grant. We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related Interpretations in accounting for our plans. We have adopted the disclosure-only provisions of SFAS 148, an amendment of SFAS 123. Therefore, no compensation cost has been recognized for stock option grants under the plans because the exercise price of all options granted was equal to 100% of the fair market value of our common stock on the respective date of each grant. A summary of stock option activity under the plans is as follows:
Fiscal Year Ended --------------------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 --------------------- --------------------- --------------------- Weighted Weighted Weighted Shares Average Shares Average Shares Average under Exercise under Exercise under Exercise Options Price Options Price Options Price ---------- -------- ---------- -------- ---------- -------- Outstanding at beginning of year 8,675,900 $ 10.52 10,703,852 $ 8.32 10,420,752 $ 6.78 Granted 1,326,500 28.77 2,170,900 17.10 4,424,000 11.41 Exercised (1,517,784) 8.92 (3,259,352) 7.35 (2,556,900) 6.60 Forfeited (342,200) 17.28 (939,500) 11.68 (1,584,000) 9.62 ---------- ---------- ---------- Outstanding at end of year 8,142,416 13.50 8,675,900 10.52 10,703,852 8.32 ========== ========== ========== Exercisable at end of year 4,448,240 $ 9.23 3,927,000 $ 8.60 5,100,852 $ 8.19 ========== ========== ==========
Exercise prices for stock options outstanding under the plans as of February 26, 2005 are summarized as follows:
Weighted Average ----------------------- Weighted Remaining Average Range of Options Contractual Exercise Options Exercise Exercise Prices Outstanding Life (Years) Price Exercisable Price ---------------- ----------- ------------ -------- ----------- -------- $ 4.30 - $ 6.33 890,890 5.2 $ 5.12 890,890 $ 5.12 $ 6.70 - $ 9.65 2,216,500 6.2 7.63 1,799,500 7.83 $ 9.68 - $14.91 2,189,500 7.2 11.57 1,479,000 11.87 $16.70 - $23.55 1,673,026 8.2 17.21 271,350 17.10 $24.15 - $29.53 1,172,500 9.1 29.32 7,500 27.11 ----------- ----------- 8,142,416 4,448,240 =========== ===========
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18 - STOCK-BASED COMPENSATION PLANS (CONTINUED) During fiscal 2005, 2004 and 2003, we awarded 219,350, 528,000 and 390,000 shares of restricted stock, respectively, to nonemployee members of our Board of Directors, officers and certain other key employees of our Company. Such shares had a weighted average fair value at the date of grant of $28, $18 and $11 per share, respectively. Recipients of restricted stock do not pay us any cash consideration for the shares. The fair value of the restricted stock award is being charged to expense over the vesting period. We recorded noncash charges to operations during fiscal 2005, 2004 and 2003 of $4.9 million, $3.3 million and $3.3 million, respectively, as compensation expense related to restricted stock. During fiscal 2004, our Board of Directors approved the Senior Staff Officer Stock Ownership Plan (the "Plan"), whereby Senior Staff Officers of our Company are required to maintain ownership of our common stock equivalent to a percentage of their base salary. Fiscal 2004 was the first year of the Plan. By the end of year five of their participation in the Plan, our Chief Executive Officer will be required to attain common stock ownership equal to two times his base salary and all other Senior Staff Officers will be required to attain common stock ownership equal to one times their base salary. In order to satisfy the common stock ownership requirements, the Plan participants must own and hold vested and unencumbered shares of our common stock. At February 26, 2005, all Senior Staff Officers were in compliance with the Plan. NOTE 19 - EMPLOYEE STOCK PURCHASE PLAN On August 2, 2004, shareholders approved the GTECH Holdings Corporation 2004 Employee Stock Purchase Plan (the "ESPP"), which replaces the July 1998 Employee Stock Purchase Plan that expired on August 31, 2004. The ESPP provides that eligible employees may purchase shares of our common stock, through regular payroll deductions, of up to 10% of their base earnings. Substantially all employees are eligible to participate in the ESPP, with the exception of those employees who are 5% or more shareholders in our Company. The purchase price of our common stock is equal to 85% of the fair market value of the stock on the first or last trading day of the six-month offering period, whichever is lower. Employees may purchase shares of our common stock having a fair market value of up to $25,000 per calendar year. All shares of our common stock purchased must be retained for a period of one year. No compensation expense is currently recorded in connection with the ESPP. The ESPP expires upon the earlier of (i) July 31, 2008; (ii) early termination by the Board of Directors or; (iii) the date the treasury shares provided by the ESPP have been purchased. A total of 1,200,000 treasury shares were made available for purchase under the ESPP, of which 1,140,355 shares remain available for future purchase as of February 26, 2005. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 20 - EMPLOYEE BENEFITS At February 26, 2005, we had two defined contribution 401(k) retirement savings and profit sharing plans (the "Plans") covering substantially all employees in the United States and the Commonwealth of Puerto Rico. Under these Plans, an eligible employee may elect to defer receipt of a portion of base pay each year. We contribute this amount on the employee's behalf to the Plans and also make a matching contribution. For periods prior to March 1, 2003, our matching contributions were equal to 100% on the first 3% and 50% on the next 2% that the employee elected to defer, up to a maximum matching contribution of 4% of the employee's base pay. Effective March 1, 2003, the matching contribution was changed to 100% on the first 3% that the employee elects to defer, up to a maximum matching contribution of 3% of the employee's base pay. Employees are fully vested at all times in the amounts they defer and in any earnings on these contributions. Employees are fully vested in the Company's matching contributions, profit sharing and any earnings on these contributions on the first anniversary of their date of hire. Benefits under the Plans will generally be paid to participants upon retirement or in certain other limited circumstances. At our discretion, we have contributed additional amounts to the Plans on behalf of employees based upon our profits for a given fiscal year. Beginning in fiscal 2005, we discontinued the payment of profit sharing contributions. Prior to fiscal 2005, we had a defined contribution Supplemental Retirement Plan (the "SRP") that provided additional retirement benefits to certain key employees. At our discretion, we contributed additional amounts to the SRP on behalf of such key employees equal to the percentage of profit sharing contributions contributed to the Plans for the calendar year multiplied by the key employees' compensation (as defined by the SRP) for such year. Beginning in fiscal 2005, we discontinued the payment of additional retirement benefits. In fiscal 2005, 2004, and 2003, we recorded expense under the plans and the SRP of $3.4 million, $7.3 million and $9.6 million, respectively. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21 - EARNINGS PER SHARE The following table shows the computation of basic and diluted earnings per share:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (In thousands, except per share amounts) NUMERATOR: Net income (Numerator for basic earnings per share) $ 196,394 $ 183,200 $ 142,021 Effect of dilutive securities: Interest expense on 1.75% Convertible Debentures, net of tax 2,125 2,126 2,056 ----------------- ----------------- ----------------- Numerator for diluted earnings per share $ 198,519 $ 185,326 $ 144,077 ================= ================= ================= DENOMINATOR: Denominator for basic earnings per share- weighted average shares 116,739 116,464 114,162 Effect of dilutive securities: 1.75% Convertible Debentures 12,727 12,727 12,727 Employee stock options 2,859 3,158 2,438 Unvested stock awards and employee stock purchase plan shares 234 276 182 ----------------- ----------------- ----------------- Dilutive potential common shares 15,820 16,161 15,347 Denominator for diluted earnings per share- adjusted weighted-average shares and assumed conversions 132,559 132,625 129,509 ================= ================= ================= Basic earnings per share $ 1.68 $ 1.57 $ 1.24 ================= ================= ================= Diluted earnings per share $ 1.50 $ 1.40 $ 1.11 ================= ================= =================
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 72.7272 shares of common stock per $1,000 principal amount of Debentures, which is equivalent to an initial conversion price of approximately $13.75 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 $16.50 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 12.7 million shares issuable upon the conversion of the Debentures. The Debentures were convertible for all 251 trading days in fiscal 2005, 209 out of 256 trading days in fiscal 2004, and were not convertible for any trading days in fiscal 2003. For all periods presented, we have adopted the provisions of EITF 04-8, which requires the inclusion of all 12.7 million shares underlying our Debentures in prior periods' diluted earnings per share computations, if dilutive, regardless of whether the conversion requirements have been met. The adoption of EITF 04-8 resulted in a decrease to diluted earnings per share of $0.02 and $0.10 in fiscal 2004 and 2003, respectively. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21 - EARNINGS PER SHARE (CONTINUED) Included in stock options outstanding are options to purchase 1,286,000, 492,000 and 1,138,000 shares of common stock at February 26, 2005, February 28, 2004 and February 22, 2003, respectively, that were not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common shares and, therefore, the effect would be anti-dilutive. NOTE 22 - INCOME TAXES Income before income taxes is based on the geographical contract source of income (rather than the location where the income is taxed) and consists of the following:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) United States $ 24,466 $ 37,355 $ 34,506 Foreign 281,920 253,439 194,560 ----------------- ----------------- ----------------- $ 306,386 $ 290,794 $ 229,066 ================= ================= =================
Significant components of the provision for income taxes were as follows:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Current: Federal $ 12,254 $ (4,145) $ 45,787 State 6,892 5,877 4,905 Foreign 56,106 46,405 37,920 ----------------- ----------------- ----------------- Total Current 75,252 48,137 88,612 ----------------- ----------------- ----------------- Deferred: Federal $ 44,007 $ 58,510 $ 3,499 State 2,532 3,049 398 Foreign (11,799) (2,102) (5,464) ----------------- ----------------- ----------------- Total Deferred 34,740 59,457 (1,567) ----------------- ----------------- ----------------- Total Provision $ 109,992 $ 107,594 $ 87,045 ================= ================= =================
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 22 - INCOME TAXES (CONTINUED) The tax effects of temporary differences and carryforwards that give rise to deferred tax assets and liabilities consist of the following:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Deferred tax assets: Accruals not currently deductible for tax purposes $ 21,933 $ 24,681 Tax credit carryforward 13,658 -- Cash collected in excess of revenue recognized 9,952 8,846 Depreciation 7,832 7,543 Inventory reserves 5,471 5,949 Foreign net operating losses 1,682 -- Interest rate swap gain 736 3,955 Other 9,677 10,380 ----------------- ----------------- 70,941 61,354 Valuation allowance for deferred tax assets (1,682) -- ----------------- ----------------- Deferred tax assets, net of valuation allowance 69,259 61,354 Deferred tax liabilities: Depreciation (111,165) (75,682) Acquired intangible assets (15,333) -- Contingent interest on convertible debt (11,371) (7,310) Other (5,965) (5,685) ----------------- ----------------- (143,834) (88,677) ----------------- ----------------- Net deferred tax liabilities $ (74,575) $ (27,323) ================= =================
At February 26, 2005, we had non-U.S. net operating loss carryforwards for income tax purposes of $4.9 million that expire at various dates through 2025. A valuation allowance at February 26, 2005 of $1.7 million has been recognized to offset the related deferred tax assets due to the uncertainty of realizing the benefits of the deferred tax assets. The valuation allowance is related to the non-U.S. net operating loss carryforwards. Undistributed earnings of foreign subsidiaries amounted to $109.1 million at February 26, 2005. If these earnings had been remitted, no additional tax cost would have been incurred because of the availability of foreign tax credits. The earnings reflect full provision for foreign income taxes and are intended to be indefinitely reinvested in foreign operations. The effective income tax rate on income before income taxes differed from the statutory federal income tax rate for the following reasons:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- Federal income tax using statutory rate 35.0% 35.0% 35.0% State taxes, net of federal benefit 2.0 2.0 1.5 Nondeductible expenses 0.4 0.4 0.5 Tax credits (0.5) (0.3) (0.7) Other (1.0) (0.1) 1.7 ----------------- ----------------- ----------------- 35.9% 37.0% 38.0% ================= ================= =================
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 23 - TRANSACTIONS WITH RELATED PARTIES Receivables from related parties, which are included in Trade Accounts Receivable in our Consolidated Balance Sheets, are as follows:
February 26, 2005 February 28, 2004 ----------------- ----------------- (Dollars in thousands) Lottery Technology Services Corporation $ 2,693 $ 2,699 Uthingo Management Proprietary Limited 1,641 2,827 Lottery Technology Enterprises 298 462 Wireless Business Solutions (Proprietary) Limited 35 -- ----------------- ----------------- $ 4,667 $ 5,988 ================= =================
LOTTERY TECHNOLOGY SERVICES CORPORATION We have a 44% interest in Lottery Technology Services Investment Corporation (the "Holding Company"), which we account for using the equity method of accounting. The Holding Company's wholly owned subsidiary, Lottery Technology Services Corporation (the "Subsidiary"), provides equipment and services (which we supplied to the Subsidiary), to the Bank of Taipei. The Bank of Taipei holds the license to operate the Taiwan Public Welfare Lottery. On November 29, 2004, the Holding Company merged with the Subsidiary and the Subsidiary is the surviving company (the merged company is collectively referred to as "LTSC"). Sales of products to, and service revenues from LTSC were $27.8 million, $27.8 million and $8.5 million in fiscal 2005, 2004 and 2003 respectively. We recognize 56% of gross profit on product sales to LTSC and defer the remaining 44% as a result of our equity interest in LTSC. We recognize these deferrals ratably over the life of our contract with LTSC. At February 26, 2005 and February 28, 2004, deferred product gross profit totaling $2.0 million and $3.4 million, respectively, is included in Deferred Revenue and Advance Billings and Other Liabilities in our Consolidated Balance Sheets. UTHINGO MANAGEMENT PROPRIETARY LIMITED We have a 10% interest in Uthingo Management Proprietary Limited ("Uthingo"), which is accounted for using the equity method of accounting. Uthingo is a corporate joint venture that holds the license to operate the South African National Lottery. Sales of products to, and service revenues from Uthingo were $18.7 million, $19.8 million and $18.0 million in fiscal 2005, 2004 and 2003, respectively. 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. LTE holds a 10-year contract (which expires in November 2009) with the District of Columbia Lottery and Charitable Games Control Board. Service revenues from LTE were $3.8 million, $3.4 million and $3.0 million in fiscal 2005, 2004 and 2003, respectively. WIRELESS BUSINESS SOLUTIONS (PROPRIETARY) LIMITED We have a 40% interest in Wireless Business Solutions (Proprietary) Limited ("WBS"), an entity that holds a national mobile data telecommunications license issued by the South African government and is the telecommunications provider to Uthingo. In fiscal 2005, we determined that we no longer had a controlling interest in WBS that would require consolidation in our financial statements due principally to the expiration of our guarantee of loans made by an unrelated commercial lender to WBS. In addition, we evaluated whether we should continue to consolidate WBS in accordance with FIN 46 and concluded consolidation was not appropriate because WBS meets the business exemption under FIN 46. Consequently, we account for WBS using the equity method of accounting. Sales of products to, and service revenues from WBS were $0.4 million in fiscal 2005. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 23 - TRANSACTIONS WITH RELATED PARTIES (CONTINUED) WEST GREENWICH TECHNOLOGY ASSOCIATES, L .P. Prior to February 1, 2005, we had 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. Prior to the third quarter of fiscal 2004, we accounted for the Partnership using the equity method of accounting. Beginning in the third quarter of fiscal 2004, we consolidated the Partnership in accordance with FIN 46 and as a result, we recorded our world headquarters facilities owned by the Partnership as an asset and the Partnership's loan as a liability in our consolidated financial statements. On February 1, 2005, we repaid the Partnership's loan and acquired the remaining 50% interest in the Partnership from the general partner. LOXLEY GTECH PRIVATE LIMITED We have a 49% interest in Loxley GTECH Private Limited Co. ("LGT"), which is accounted for using the equity method of accounting. LGT is a corporate joint venture that is expected to provide the online lottery system in Thailand. There were no sales of products to, or service revenues from LGT during fiscal 2005, 2004 or 2003. SPELPARKEN We have a 19% interest in Spelparken which is accounted for using the equity method of accounting. Spelparken is a corporate joint venture that will provide internet gaming related activities in Sweden. There were no sales of products to, or service revenues from Spelparken during fiscal 2005, 2004 or 2003. ITALY (COGETECH SPA) We have a 35% interest in Cogetech SPA which is accounted for using the equity method of accounting. Cogetech SPA is a corporate joint venture that operates a communications network and related central computer system linking gaming machines in Italy. There were no sales of products to Cogetech SPA during fiscal 2005, 2004 or 2003. We have deferred approximately $0.4 million of service revenue during fiscal 2005, which will be recognized as collected in fiscal 2006. DELAWARE LLC At February 28, 2004, we held a 50% interest in Gaming Entertainment (Delaware) L.L.C. ("GED"), an entity that manages a racino for Harrington Raceway, Inc. ("Harrington"). During the first quarter of fiscal 2005, we sold our 50% interest in GED to Harrington for $11.8 million and recognized a gain of $10.9 million which was recorded in Other Income (Expense) in our Consolidated Income Statements. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 24 - LEASES We lease certain facilities, equipment and vehicles under noncancelable operating leases that expire at various dates through fiscal 2015. Certain of these leases have escalation clauses and renewal options. We are required to pay all maintenance costs, taxes and insurance premiums relating to our leased assets. Future minimum lease payments for noncancelable operating leases with initial lease terms in excess of one year at February 26, 2005 were as follows:
Lease Fiscal Year Payments ----------- -------------- (in thousands) 2006 $ 20,572 2007 15,362 2008 7,385 2009 4,956 2010 3,892 Thereafter 4,326 -------------- Total minimum lease payments $ 56,493 ==============
Rental expense for operating leases was $32.1 million, $27.9 million and $26.4 million for fiscal 2005, 2004, and 2003, respectively. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 25 - BUSINESS SEGMENT AND GEOGRAPHIC DATA We are a global technology services company providing software, networks and professional services that power high-performance solutions. We have a single operating and reportable business segment, the Transaction Processing segment, with our core market being the lottery industry. The accounting policies of the Transaction Processing segment are the same as those described in Note 1 - "Organization and Summary of Significant Accounting Policies." Management evaluates the performance of this segment based on operating income. The Company's geographic data, based on the location of the customer, is summarized below:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Revenues from external sources: United States $ 599,914 $ 531,776 $ 496,908 Brazil 93,084 106,913 100,371 United Kingdom 68,702 85,595 54,824 Poland 68,499 47,116 23,766 Other foreign 427,036 279,930 302,921 ----------------- ----------------- ----------------- $ 1,257,235 $ 1,051,330 $ 978,790 ================= ================= =================
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Systems, equipment and other assets relating to contracts, net: United States $ 587,595 $ 482,118 $ 298,732 Poland 40,857 27,032 14,787 Other foreign 91,986 82,212 97,392 ----------------- ----------------- ----------------- $ 720,438 $ 591,362 $ 410,911 ================= ================= =================
There were no customers that accounted for more than 10% of our consolidated revenues in fiscal 2005, 2004 or 2003. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 26 - SUBSEQUENT EVENTS DEVELOPMENTS IN BRAZIL A June 25, 2004 ruling (the "Ruling") in a civil action initiated by federal attorneys with Brazil's Public Ministry had the effect in fiscal 2005 of materially reducing payments that we otherwise would have received from our lottery contract with Caixa Economica Federal ("CEF"), our customer and the operator of Brazil's National Lottery, which expires in May 2005. The Ruling ordered that 30% of payments subsequent to the Ruling due to GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH Brazil") from CEF, be withheld and deposited in an account maintained by the Court. As of February 26, 2005, the total amount withheld and deposited in an account maintained by the Court was approximately 68 million Brazilian reals, or $26 million. In fiscal 2005, we did not recognize service revenues for the payments that were withheld from GTECH Brazil, as realization of these amounts was not reasonably assured. In July 2004 we filed an appeal of the Ruling and in March 2005 (after the close of fiscal 2005), an appellate court decision ordered that the withholding be discontinued and that all funds currently held in escrow in excess of 40 million Brazilian reals be returned to us, which amounts to $11 million of the $26 million withheld as of February 26, 2005. We received and recognized these funds as service revenue on April 13, 2005. In addition, the Ruling ordered that all assets of GTECH Brazil be identified to the Court so as to prevent their transfer or disposition, a requirement that was also subsequently reversed by the appellate court decision in March 2005. Refer to Note 14 for detailed disclosures regarding this matter. ATRONIC In December 2004, we entered into an agreement to acquire a 50% controlling equity position in the Atronic group of companies ("Atronic") owned by the owners of the privately-held Gauselmann Group ("Gauselmann"). The remaining 50% of Atronic will be retained by the owners of Gauselmann. Atronic is a video slot machine manufacturer and also develops slot machine games and customized solutions for dynamic gaming operations. This transaction is contingent upon regulatory and gaming license approvals and other closing conditions, and is expected to be completed on December 31, 2006. On March 24, 2005, we guaranteed 50% of Atronic's obligations due under a Euro 50 million (approximately $65 million at the April 20, 2005 exchange rate) loan made by an unrelated commercial lender to Atronic (the "Agreement"). Our maximum liability under this guaranty is equal to the lesser of Euro 25 million (approximately $33 million at the April 20, 2005 exchange rate) or 50% of Atronic's outstanding obligations under the Agreement. The guarantee arose in connection with our planned acquisition of Atronic on December 31, 2006. We would be required to perform under the guaranty should Atronic fail to make any interest or principal payments in accordance with the terms and conditions of the Agreement. Our guarantee expires on April 26, 2010. LOXLEY GTECH PRIVATE LIMITED We have a 49% interest in Loxley GTECH Private Limited Co. ("LGT"), which is accounted for using the equity method of accounting. LGT is a corporate joint venture that is expected to provide the online lottery system in Thailand. On March 29, 2005, in order to assist LGT with obtaining the financing they require to enable them to perform under their anticipated obligation to operate the online lottery system in Thailand, we guaranteed, along with the other 51% shareholder in LGT, Baht 1.925 billion (approximately $49 million at the April 20, 2005 exchange rate) principal amount in loans and Baht 455 million (approximately $12 million at the April 20, 2005 exchange rate) in performance bonds and trade finance facilities made to LGT by an unrelated commercial lender (collectively the "Facilities"). We are jointly and severally liable with the other shareholder in LGT for this guarantee. We would be required to perform under the guaranty should LGT fail to make interest or principal payments in accordance with the terms and conditions of the Facilities. Our guarantee obligations will not commence until LGT enters into a definitive agreement with the government, which we currently expect will take place in the second quarter of fiscal 2006, and will terminate upon the start-up of the online lottery system in Thailand, which is currently expected to occur in the fourth quarter of fiscal 2006. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 27 - SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information is summarized as follows:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Income taxes paid $ 67,677 $ 66,729 $ 76,944 Interest paid, net of amounts capitalized 16,412 5,725 11,266 Income tax refunds (10,465) (1,995) (1,901)
Non-cash investing and financing activities are excluded from the consolidated statement of cash flows. Non-cash activities are summarized as follows:
Fiscal Year Ended --------------------------------------------------------- February 26, 2005 February 28, 2004 February 22, 2003 ----------------- ----------------- ----------------- (Dollars in thousands) Non-cash investment related to our new world headquarters facility in Providence, RI $ 6,604 $ -- $ -- Treasury shares issued under stock award plans 3,139 2,437 3,508 Issuance of 1,435,130 shares of Holding common stock in connection with the acquisition of Interlott Technologies, Inc. -- 30,834 --
NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION On December 18, 2001, Holdings (the "Parent Company") issued, in a private placement, $175 million principal amount of 1.75% Convertible Debentures due December 15, 2021 (the "Debentures"). On October 9, 2003, the Parent Company issued, in a private placement, $250 million principal amount of 4.75% Senior Notes due October 15, 2010, all of which were subsequently exchanged for 4.75% Senior Notes due October 15, 2010 registered under the Securities Act of 1933 and on November 16, 2004, the Parent Company issued $150 million principal amount of 4.75% Senior Notes due December 1, 2009 and $150 million principal amount of 5.75% Senior Notes due December 1, 2014 (collectively, the "Senior Notes"). The Debentures and Senior Notes are unsecured and unsubordinated obligations of the Parent Company that are jointly and severally, fully and unconditionally guaranteed by GTECH and two of its wholly owned subsidiaries: GTECH Rhode Island Corporation and GTECH Latin America Corporation (collectively with GTECH, the "Guarantor Subsidiaries"). Condensed consolidating financial information is presented below. Selling, general and administrative costs and research and development costs are allocated to each subsidiary based on the ratio of the subsidiaries' combined service revenues and sales of products to consolidated revenues. The Parent Company conducts business through its consolidated subsidiaries and unconsolidated affiliates and has, as its only material asset, an investment in GTECH. Equity in earnings of consolidated affiliates recorded by the Parent Company includes the Parent Company's share of the after-tax earnings of GTECH. Taxes payable and deferred income taxes are obligations of the subsidiaries. Income tax expense related to both current and deferred income taxes are allocated to each subsidiary based on our consolidated effective income tax rates. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Balance Sheets February 26, 2005
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Assets Current Assets: Cash and cash equivalents $ -- $ 23,020 $ 71,426 $ -- $ 94,446 Investment securities available-for-sale -- 196,825 -- -- 196,825 Trade accounts receivable, net -- 82,212 86,494 -- 168,706 Due from subsidiaries and affiliates -- 53,345 -- (53,345) -- Sales-type lease receivables -- 3,215 246 -- 3,461 Refundable performance deposit -- -- 8,000 -- 8,000 Inventories -- 30,387 34,366 (3,618) 61,135 Deferred income taxes -- 14,030 17,405 -- 31,435 Other current assets -- 6,669 19,977 -- 26,646 -------- ------------ ------------- ----------- ------------ Total Current Assets -- 409,703 237,914 (56,963) 590,654 Systems, Equipment and Other Assets Relating to Contracts, net -- 616,204 118,436 (14,202) 720,438 Investment in Subsidiaries and Affiliates 655,768 448,499 -- (1,104,267) -- Goodwill, net -- 115,981 215,041 -- 331,022 Property, Plant and Equipment, net -- 40,120 34,438 -- 74,558 Intangible Assets, net -- 22,157 48,682 -- 70,839 Refundable Performance Deposit -- -- 12,000 -- 12,000 Sales-Type Lease Receivables -- 4,681 75 -- 4,756 Other Assets -- 28,209 22,665 -- 50,874 -------- ------------ ------------- ----------- ------------ Total Assets $655,768 $ 1,685,554 $ 689,251 $(1,175,432) $ 1,855,141 ======== ============ ============= =========== ============ Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ -- $ 41,525 $ 57,709 $ -- $ 99,234 Due to subsidiaries and affiliates -- -- 53,345 (53,345) -- Accrued expenses -- 29,277 24,950 -- 54,227 Employee compensation -- 13,252 8,610 -- 21,862 Advance payments from customers -- 8,113 34,752 -- 42,865 Deferred revenue and advance billings -- 11,369 18,336 -- 29,705 Income taxes payable -- 11,902 4,597 -- 16,499 Taxes other than income taxes -- 7,688 8,884 -- 16,572 Short-term borrowings -- -- 334 -- 334 Current portion of long-term debt -- -- 2,476 -- 2,476 -------- ------------ ------------- ----------- ------------ Total Current Liabilities -- 123,126 213,993 (53,345) 283,774 Long-Term Debt, less current portion -- 723,539 2,790 -- 726,329 Other Liabilities -- 64,035 19,225 -- 83,260 Deferred Income Taxes -- 101,266 4,744 -- 106,010 Shareholders' Equity 655,768 673,588 448,499 (1,122,087) 655,768 -------- ------------ ------------- ----------- ------------ Total Liabilities and Shareholders' Equity $655,768 $ 1,685,554 $ 689,251 $(1,175,432) $ 1,855,141 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Balance Sheets February 28, 2004
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Assets Current Assets: Cash and cash equivalents $ -- $ 68,956 $ 60,383 $ -- $ 129,339 Investment securities available-for-sale -- 221,850 -- -- 221,850 Trade accounts receivable, net -- 75,590 43,312 -- 118,902 Due from subsidiaries and affiliates -- 49,168 -- (49,168) -- Sales-type lease receivables -- 3,967 3,738 -- 7,705 Inventories -- 52,697 29,943 (5,856) 76,784 Deferred income taxes -- 30,254 4,142 -- 34,396 Other current assets -- 5,481 18,945 -- 24,426 -------- ------------ ------------- ----------- ------------ Total Current Assets -- 507,963 160,463 (55,024) 613,402 Systems, Equipment and Other Assets Relating to Contracts, net -- 518,976 80,111 (7,725) 591,362 Investment in Subsidiaries and Affiliates 562,289 162,788 -- (725,077) -- Goodwill, net -- 115,965 72,647 -- 188,612 Property, Plant and Equipment, net -- 28,543 29,033 -- 57,576 Intangible Assets, net -- 21,850 6,381 -- 28,231 Refundable Performance Deposit -- -- 20,000 -- 20,000 Sales-Type Lease Receivables -- 8,125 9,528 -- 17,653 Other Assets -- 20,822 21,473 -- 42,295 -------- ------------ ------------- ----------- ------------ Total Assets $562,289 $ 1,385,032 $ 399,636 $ (787,826) $ 1,559,131 -------- ------------ ------------- ----------- ------------ Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ -- $ 54,967 $ $ 25,037 $ -- $ 80,004 Due to subsidiaries and affiliates -- -- 49,168 (49,168) -- Accrued expenses -- 32,041 15,387 -- 47,428 Employee compensation -- 29,256 4,725 -- 33,981 Advance payments from customers -- 45,648 58,480 -- 104,128 Deferred revenue and advance billings -- 8,282 6,177 -- 14,459 Income taxes payable -- 4,419 7,975 -- 12,394 Taxes other than income taxes -- 8,643 10,816 -- 19,459 Current portion of long-term debt -- 100,886 5,433 -- 106,319 -------- ------------ ------------- ----------- ------------ Total Current Liabilities -- 284,142 183,198 (49,168) 418,172 Long-Term Debt, less current portion -- 430,652 32,563 -- 463,215 Other Liabilities -- 36,526 17,210 -- 53,736 Deferred Income Taxes -- 57,842 3,877 -- 61,719 Shareholders' Equity 562,289 575,870 162,788 (738,658) 562,289 -------- ------------ ------------- ----------- ------------ Total Liabilities and Shareholders' Equity $562,289 $ 1,385,032 $ 399,636 $ (787,826) $ 1,559,131 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Income Statements Fiscal Year Ended February 26, 2005
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Revenues: Services $ -- $ 718,920 $ 298,763 $ -- $ 1,017,683 Sales of products -- 105,848 133,704 -- 239,552 Intercompany sales and fees -- 95,463 63,651 (159,114) -- -------- ------------ ------------- ----------- ------------ -- 920,231 496,118 (159,114) 1,257,235 Costs and expenses: Costs of services -- 417,553 202,522 (3,442) 616,633 Costs of sales -- 56,515 101,472 (13) 157,974 Intercompany cost of sales and fees -- 103,009 22,008 (125,017) -- -------- ------------ ------------- ----------- ------------ -- 577,077 326,002 (128,472) 774,607 -------- ------------ ------------- ----------- ------------ Gross profit -- 343,154 170,116 (30,642) 482,628 Selling, general & administrative -- 76,904 40,349 -- 117,253 Research and development -- 34,482 18,077 -- 52,559 -------- ------------ ------------- ----------- ------------ Operating expenses -- 111,386 58,426 -- 169,812 -------- ------------ ------------- ----------- ------------ Operating income -- 231,768 111,690 (30,642) 312,816 Other income (expense): Interest income -- 2,137 2,478 -- 4,615 Equity in earnings of unconsolidated affiliates -- 2,891 (79) -- 2,812 Equity in earnings of consolidated affiliates 196,394 74,146 -- (270,540) -- Other income -- 2,571 2,785 -- 5,356 Interest expense -- (17,922) (1,291) -- (19,213) -------- ------------ ------------- ----------- ------------ 196,394 63,823 3,893 (270,540) (6,430) -------- ------------ ------------- ----------- ------------ Income before income taxes 196,394 295,591 115,583 (301,182) 306,386 Income taxes -- 105,969 41,437 (37,414) 109,992 -------- ------------ ------------- ----------- ------------ Net income $196,394 $ 189,622 $ 74,146 $ (263,768) $ 196,394 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Income Statements Fiscal Year Ended February 28, 2004
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Revenues: Services $ -- $ 684,299 $ 273,172 $ -- $ 957,471 Sales of products -- 40,643 53,216 -- 93,859 Intercompany sales and fees -- 101,932 47,881 (149,813) -- -------- ------------ ------------- ----------- ------------ -- 826,874 374,269 (149,813) 1,051,330 Costs and expenses: Costs of services -- 372,109 169,451 (3,721) 537,839 Costs of sales -- 21,433 37,856 (63) 59,226 Intercompany cost of sales and fees -- 100,111 20,865 (120,976) -- -------- ------------ ------------- ----------- ------------ -- 493,653 228,172 (124,760) 597,065 -------- ------------ ------------- ----------- ------------ Gross profit -- 333,221 146,097 (25,053) 454,265 Selling, general & administrative -- 75,213 33,879 -- 109,092 Research and development -- 39,530 17,788 -- 57,318 -------- ------------ ------------- ----------- ------------ Operating expenses -- 114,743 51,667 -- 166,410 -------- ------------ ------------- ----------- ------------ Operating income -- 218,478 94,430 (25,053) 287,855 Other income (expense): Interest income -- 1,882 3,851 -- 5,733 Equity in earnings of unconsolidated affiliates -- 2,038 4,198 -- 6,236 Equity in earnings of consolidated affiliates 183,200 61,334 -- (244,534) -- Other income (expense) -- 5,817 (3,928) -- 1,889 Interest expense -- (9,724) (1,195) -- (10,919) -------- ------------ ------------- ----------- ------------ 183,200 61,347 2,926 (244,534) 2,939 -------- ------------ ------------- ----------- ------------ Income before income taxes 183,200 279,825 97,356 (269,587) 290,794 Income taxes -- 103,535 36,022 (31,963) 107,594 -------- ------------ ------------- ----------- ------------ Net income $183,200 $ 176,290 $ 61,334 $ (237,624) $ 183,200 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Income Statements Fiscal Year Ended February 22, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Revenues: Services $ -- $ 658,815 $ 210,081 $ -- $ 868,896 Sales of products -- 58,310 51,584 -- 109,894 Intercompany sales and fees -- 96,058 58,756 (154,814) -- -------- ------------ ------------- ----------- ------------ -- 813,183 320,421 (154,814) 978,790 Costs and expenses: Costs of services -- 383,256 177,663 (25,878) 535,041 Costs of sales -- 49,578 29,799 (434) 78,943 Intercompany cost of sales and fees -- 65,446 21,671 (87,117) -- -------- ------------ ------------- ----------- ------------ -- 498,280 229,133 (113,429) 613,984 -------- ------------ ------------- ----------- ------------ Gross profit -- 314,903 91,288 (41,385) 364,806 Selling, general & administrative -- 70,434 25,696 -- 96,130 Research and development -- 31,391 11,461 -- 42,852 Special charge (credit) -- (1,121) -- -- (1,121) -------- ------------ ------------- ----------- ------------ Operating expenses -- 100,704 37,157 -- 137,861 -------- ------------ ------------- ----------- ------------ Operating income -- 214,199 54,131 (41,385) 226,945 Other income (expense): Interest income -- 1,597 2,240 -- 3,837 Equity in earnings of unconsolidated affiliates -- 3,499 3,877 -- 7,376 Equity in earnings of consolidated affiliates 142,021 40,991 -- (183,012) -- Other income (expense) -- (5,930) 8,105 -- 2,175 Interest expense -- (9,028) (2,239) -- (11,267) -------- ------------ ------------- ----------- ------------ 142,021 31,129 11,983 (183,012) 2,121 -------- ------------ ------------- ----------- ------------ Income before income taxes 142,021 245,328 66,114 (224,397) 229,066 Income taxes -- 93,225 25,123 (31,303) 87,045 -------- ------------ ------------- ----------- ------------ Net income $142,021 $ 152,103 $ 40,991 $ (193,094) $ 142,021 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Statements of Cash Flows Fiscal Year Ended February 26, 2005
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated --------- ------------ ------------- ----------- ------------ (Dollars in thousands) Net cash provided by operating activities $ -- $ 262,868 $ 122,821 $ (10,480) $ 375,209 Investing Activities Acquisitions (net of cash acquired) -- -- (200,730) -- (200,730) Purchases of systems, equipment and other assets relating to contracts -- (204,163) (51,909) 10,480 (245,592) Purchases of available-for-sale investment securities -- (246,975) -- -- (246,975) Maturities and sales of available-for-sale investment securities -- 272,000 -- -- 272,000 Proceeds from sale of investment -- -- 11,773 -- 11,773 Purchases of property, plant and equipment -- (12,331) (544) -- (12,875) Increase in restricted cash -- -- (5,112) -- (5,112) Investments in and advances to unconsolidated subsidiaries -- -- (2,071) -- (2,071) --------- ------------ ------------- ----------- ------------ Net cash used for investing activities -- (191,469) (248,593) 10,480 (429,582) Financing Activities Net proceeds from issuance of long-term debt -- 343,254 -- -- 343,254 Principal payments on long-term debt -- (135,000) (32,692) -- (167,692) Purchases of treasury stock (120,658) -- -- -- (120,658) Dividends paid (39,830) -- -- -- (39,830) Premiums and fees paid in connection with the early retirement of debt -- (10,610) -- -- (10,610) Proceeds from stock options 13,546 -- -- -- 13,546 Intercompany capital transactions 144,948 (312,948) 168,000 -- -- Other 1,994 (2,904) 405 -- (505) --------- ------------ ------------- ----------- ------------ Net cash provided by (used for) financing activities -- (118,208) 135,713 -- 17,505 Effect of exchange rate changes on cash -- 873 1,102 -- 1,975 --------- ------------ ------------- ----------- ------------ Increase (decrease) in cash and cash equivalents -- (45,936) 11,043 -- (34,893) Cash and cash equivalents at beginning of year -- 68,956 60,383 -- 129,339 --------- ------------ ------------- ----------- ------------ Cash and cash equivalents at end of year $ -- $ 23,020 $ 71,426 $ -- $ 94,446 ========= ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Statements of Cash Flows Fiscal Year Ended February 28, 2004
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Net cash provided by operating activities $ -- $ 339,643 $ 76,286 $ (862) $ 415,067 Investing Activities Purchases of systems, equipment and other assets relating to contracts -- (252,273) (16,599) 862 (268,010) Purchases of available-for-sale investment securities -- (242,050) -- -- (242,050) Acquisitions (net of cash acquired) -- (40,691) (33,751) -- (74,442) Refundable performance deposit -- -- (20,000) -- (20,000) Purchases of property, plant and equipment -- (12,772) -- -- (12,772) License fee -- (12,500) -- -- (12,500) Investments in and advances to unconsolidated subsidiaries -- (1,185) (1,700) -- (2,885) Maturities and sales of available-for-sale investment securities -- 20,200 -- -- 20,200 -------- ------------ ------------- ----------- ------------ Net cash used for investing activities -- (541,271) (72,050) 862 (612,459) Financing Activities Net proceeds from issuance of long-term debt -- 251,006 1,582 -- 252,588 Principal payments on long-term debt -- (27,759) (5,534) -- (33,293) Proceeds from stock options 23,943 -- -- -- 23,943 Dividends paid (29,977) -- -- -- (29,977) Premiums and fees paid in in connection with the early retirement of debt -- (731) -- -- (731) Intercompany capital transactions 4,959 (38,710) 33,751 -- -- Other 1,075 (2,125) (5,274) -- (6,324) -------- ------------ ------------- ----------- ------------ Net cash provided by financing activities -- 181,681 24,525 -- 206,206 Effect of exchange rate changes on cash -- 164 4,187 -- 4,351 -------- ------------ ------------- ----------- ------------ Increase (decrease) in cash and cash equivalents -- (19,783) 32,948 -- 13,165 Cash and cash equivalents at beginning of year -- 88,739 27,435 -- 116,174 -------- ------------ ------------- ----------- ------------ Cash and cash equivalents at end of year $ -- $ 68,956 $ 60,383 $ -- $ 129,339 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 28 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (CONTINUED) Condensed Consolidating Statements of Cash Flows Fiscal Year Ended February 22, 2003
Parent Guarantor Non-Guarantor Eliminating Company Subsidiaries Subsidiaries Entries Consolidated -------- ------------ ------------- ----------- ------------ (Dollars in thousands) Net cash provided by operating activities $ -- $ 294,549 $ 39,497 $ (1,790) $ 332,256 Investing Activities Purchases of systems, equipment and other assets relating to contracts -- (135,465) (21,881) 1,790 (155,556) Proceeds from sale of investments -- 2,560 -- -- 2,560 Purchases of property, plant and equipment -- (5,612) -- -- (5,612) -------- ------------ ------------- ----------- ------------ Net cash used for investing activities -- (138,517) (21,881) 1,790 (158,608) Financing Activities Principal payments on long-term debt -- (43,571) (3,845) -- (47,416) Purchases of treasury stock (64,032) -- -- -- (64,032) Proceeds from stock options 16,867 -- -- -- 16,867 Intercompany capital transactions 46,282 (46,282) -- -- -- Premiums and fees paid in connection with the early retirement of debt -- (3,434) -- -- (3,434) Other 883 (120) 1,059 -- 1,822 -------- ------------ ------------- ----------- ------------ Net cash used for financing activities -- (93,407) (2,786) -- (96,193) Effect of exchange rate changes on cash -- 249 3,375 -- 3,624 -------- ------------ ------------- ----------- ------------ Increase in cash and cash equivalents -- 62,874 18,205 -- 81,079 Cash and cash equivalents at beginning of year -- 25,865 9,230 -- 35,095 -------- ------------ ------------- ----------- ------------ Cash and cash equivalents at end of year $ -- $ 88,739 $ 27,435 $ -- $ 116,174 ======== ============ ============= =========== ============
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 29 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the unaudited quarterly results of operations for fiscal 2005 and 2004:
First Second Third Fourth Quarter Quarter Quarter Quarter -------- -------- -------- -------- (Dollars in thousands, except per share amounts) Fiscal year ended February 26, 2005: Service revenues $253,326 $248,114 $251,945 $264,298 Sales of products 26,879 75,401 63,702 73,570 Gross profit 116,995 131,160 115,498 118,975 Net income 53,615 53,081 45,855 43,843 Basic earnings per share $ .46 $ .45 $ .40 $ .38 Diluted earnings per share .40 .40 .35 .34 Fiscal year ended February 28, 2004: Service revenues $223,538 $238,019 $231,225 $264,689 Sales of products 16,047 39,228 23,697 14,887 Gross profit 104,159 115,632 109,837 124,637 Net income 41,026 48,476 45,867 47,831 Basic earnings per share $ .36 $ .42 $ .39 $ .40 Diluted earnings per share .32 .37 .35 .36
We operate on a 52-week or 53-week fiscal year ending on the last Saturday in February. Fiscal 2005 was a 52-week year. Fiscal 2004 was a 53-week year and we included the extra week in our fourth quarter ending February 28, 2004. Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly basic and diluted earnings per share in fiscal 2005 does not equal the total computed for that year. During the first quarter of fiscal 2005, we sold our 50% interest in Gaming Entertainment (Delaware) L.L.C. for $11.8 million and recognized a gain of $10.9 million which was recorded in Other Income (Expense) in our Consolidated Income Statements. During the first quarter of fiscal 2005, we recorded a net charge of $0.8 million in connection with the repurchase of $90.0 million of our 7.87% Series B Guaranteed Senior Notes due May 2007, which is included in Other Income (Expense) in our Consolidated Income Statements. During the third quarter of fiscal 2004, we recorded a pre-tax gain of $5.3 million in connection with the consolidation of our 50% limited partnership interest in West Greenwich Technology Associates, L.P., which is included in Other Income (Expense) in our Consolidated Income Statements. Refer to Note 17 for detailed disclosures. GTECH HOLDINGS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 29 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (CONTINUED) In October 2004, the FASB ratified the Emerging Issues Task Force's consensus on Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-8"), which is effective for periods ending after December 15, 2004. Under current interpretations of FAS 128, "Earnings per Share", issuers of contingently convertible debt instruments exclude the potential common shares underlying the debt instrument from the calculation of diluted earnings per share until the contingency is met. EITF 04-8 requires that potential shares underlying the debt instrument be included in diluted earnings per share computations, if dilutive, regardless of whether the contingency has been met. We adopted EITF 04-8 in December 2004 and retroactively adjusted all prior period diluted earnings per share amounts to conform to the guidance in EITF 04-8. There were no changes to reported diluted earnings per share except in the first quarter of fiscal 2004 where the diluted earnings per share decreased from $0.34 to $0.32. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES: We have established disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to the officers who certify the Company's financial reports and to other members of senior management and the Board of Directors. Based on their evaluation as of February 26, 2005, the principal executive officer and principal financial officer of the Company have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were effective as of February 26, 2005. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING: Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of February 26, 2005 based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based upon our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of February 26, 2005. Management's assessment of the effectiveness of our internal control over financial reporting as of February 26, 2005 has been audited by Ernst & Young, LLP, an independent registered public accounting firm, as stated in their report which follows. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders GTECH Holdings Corp. We have audited management's assessment, included in the accompanying Management's Report of Internal Control Over Financial Reporting that GTECH Holdings Corporation and subsidiaries maintained effective internal control over financial reporting as of February 26, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). GTECH Holdings Corporation and subsidiaries' management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that GTECH Holdings Corporation and subsidiaries maintained effective internal control over financial reporting as of February 26, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, GTECH Holdings Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of February 26, 2005, based on the COSO criteria. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of GTECH Holdings Corporation and subsidiaries as of February 26, 2005 and February 28, 2004, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended February 26, 2005 and our report dated April 22, 2005 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Boston, Massachusetts April 22, 2005 ITEM 9B. OTHER INFORMATION Not applicable. PART III INCORPORATED BY REFERENCE The information called for by Part III (Item 10 - "Directors and Executive Officers of the Registrant" (other than the information concerning executive officers set forth after Item 4 herein), Item 11 - "Executive Compensation," Item 12 - "Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters", Item 13 - "Certain Relationships and Related Transactions" and Item 14 - "Principal Accountant Fees and Services") of Form 10-K is incorporated herein by reference to Holdings' definitive proxy statement for its Annual Meeting of Shareholders scheduled to be held in August 2005, which definitive proxy statement is expected to be filed with the Commission not later than 120 days after the end of the fiscal year to which this report relates. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1) Financial Statements:
Page(s) ------- Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
The following consolidated financial statements of GTECH Holdings Corporation and subsidiaries are included in Item 8: Consolidated Balance Sheets at February 26, 2005 and February 28, 2004 Consolidated Income Statements Fiscal year ended February 26, 2005 Fiscal year ended February 28, 2004, and Fiscal year ended February 22, 2003 Consolidated Statements of Cash Flows Fiscal year ended February 26, 2005 Fiscal year ended February 28, 2004, and Fiscal year ended February 22,2003 Consolidated Statements of Shareholders' Equity Fiscal year ended February 26, 2005 Fiscal year ended February 28, 2004, and Fiscal year ended February 22, 2003 Notes to Consolidated Financial Statements (2) FINANCIAL STATEMENT SCHEDULES TO GTECH HOLDINGS CORPORATION AND SUBSIDIARIES: Schedule II - Valuation and Qualifying Accounts All other financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) EXHIBITS: 3.1 Restated Certificate of Incorporation of Holdings, as amended (incorporated by reference to Exhibit 3.1 to the Form S-l of Holdings and GTECH Corporation ("GTECH"), Registration No. 33-31867 (the "1990 S-1"). 3.2 Certificate of Amendment to the Certificate of Incorporation of Holdings (incorporated by reference to Exhibit 3.2 to the Form S-1 of Holdings, Registration No. 33-48264 (the "July 1992 S-1")). 3.3 Certificate of Amendment of the Certificate of Incorporation of Holdings (incorporated by reference to Appendix C of Holdings' 2004 Notice of Annual Meeting and Proxy Statement). 3.4 Amended and Restated By-Laws of Holdings (incorporated by reference to Exhibit 3.3 of Holdings' Form 10-K for the fiscal year ended February 28, 2004 (the "2004 10-K")). 4.1 Credit Agreement, dated June 22, 2001, by and among GTECH, as Borrower, Bank of America, N.A., as Administrative Agent and as Lender and the Lenders party thereto from time to time (incorporated by reference to Exhibit 10.1 of Holdings' 10-Q for the quarterly period ended May 26, 2001). 4.2 Indenture, dated as of December 18, 2001, by and among Holdings, GTECH, GTECH Rhode Island Corporation, GTECH Latin America Corporation, and The Bank of New York (incorporated by reference to Exhibit 4.1 of Holdings' 10-Q for the quarterly period ended November 24, 2001). 4.3 Registration Rights Agreement, dated December 18, 2001, by and among Credit Suisse First Boston Corporation, Bank of America Securities LLC, and Merrill Lynch, Pierce Fenner & Smith Incorporated, as Representatives, and Holdings, GTECH, GTECH Rhode Island Corporation, and GTECH Latin America Corporation (incorporated by reference to Exhibit 4.2 of Holdings' 10-Q for the quarterly period ended November 24, 2001). 4.4 Specimen Form of certificate of Common Stock (incorporated by reference to Exhibit 4.18 of the S-1 of Holdings, Registration No. 33-54236). 10.1 Agreement, dated as of August 9, 2000, between Holdings and W. Bruce Turner (incorporated by reference to Exhibit 10.3 of Holdings' 10-Q for the quarterly period ended August 26, 2000).* 10.2 Amendment, dated as of June 1, 2001, to the Agreement, dated as of August 9, 2000 by and between Holdings and W. Bruce Turner (incorporated by reference to Exhibit 10.3 of Holdings' 10-Q for the quarterly period ended May 26, 2001).* 10.3 Agreement, dated as of August 6, 2002, among Holdings, GTECH and W. Bruce Turner (incorporated by reference to Exhibit 10.1 of Holdings' 10-Q for the Quarterly Period ended August 24, 2002).* 10.4 Separation Agreement and Release, dated as of August 21, 2003, by and among Holdings, the Company and Antonio Carlos Rocha (incorporated by reference to Exhibit 10.8 of Holdings' 2004 10-K).* 10.5 Separation Agreement and Mutual Release, dated as of January 7, 2004, by and among Holdings, the Company and Larry Smith (incorporated by reference to Exhibit 10.9 of Holdings' 2004 10-K).* +10.6 Severance Agreement and Release, dated as of November 24, 2004, by and among Holdings and Kathleen McKeough.* 10.7 Form of Agreement, relating to a potential change of control involving Holdings, entered into between Holdings and, respectively, certain members of senior management (incorporated by reference to Exhibit 10.5 of Holdings' 2000 10-K).* 10.8 List of signatories to Agreement relating to potential change of control involving Holdings and certain members of senior management, with the respective dates of such Agreements (incorporated by reference to Exhibit 10.9 of Holdings' 2003 10-K).* 10.9 Form of Executive Separation Agreement (incorporated by reference to Exhibit 10.12 of Holdings' 2003 10-K).* +10.10 Schedule of Recipients of Executive Separation Agreements.* +10.11 Schedule of Recipients of Company Contributions to Income Deferral plan. 10.12 Contract for Lottery Operations and Services, dated October 10, 2001, by and between the Texas Lottery Commission and GTECH (incorporated by reference to Exhibit 10.1 of Holdings' 10-Q for the quarterly period ended November 24, 2001.) 10.13 Amendment No. 1 to Contract for Lottery Operations and Services, dated October 18, 2001, by and between the Texas Lottery Commission and GTECH (incorporated by reference to Exhibit 10.2 of Holdings' 10-Q for the quarterly period ended November 24, 2001). 10.14 Agreement between Caixa Economica Federal and RACIMEC Informatica Brasileira S.A. (predecessor to GTECH Brasil Ltda.) dated May 26, 2000, respecting the provision of goods and services for the Brazil National Lottery (incorporated by reference to Exhibit 10.12 of Holdings' 2000 10-K). 10.15 Amendment to Agreement between Caixa Economica Federal and RACIMEC Informatica Brasileira S.A. (predecessor to GTECH Brasil Ltda.) (incorporated by reference to Exhibit 10.21 of Holdings' 2001 10-K). 10.16 Amendment to Agreement between CEF and GTECH Brasil Ltda., dated September 14, 2001 (incorporated by reference to Exhibit 10.20 of Holdings' 2003 10-K). 10.17 Amendment to Agreement between CEF and GTECH Brasil Ltda., dated July 1, 2002 (incorporated by reference to Exhibit 10.21 of Holdings' 2003 10-K). 10.18 Amendment to Agreement between CEF and GTECH Brasil Ltda., dated January 14, 2003 (incorporated by reference to Exhibit 10.22 of Holdings' 2003 10-K). 10.19 Fifth Amendment to Agreement between CEF and GTECH Brasil Ltda., dated April 8, 2003 (incorporated by reference to Exhibit 10.23 of Holdings' 2003 10-K). 10.20 Master Contract, dated as of May 12, 2003, by and between the Company and the Rhode Island Lottery (incorporated by reference to Exhibit 10.2 of Holdings' 10-Q for the quarterly period ended May 24, 2003). 10.21 Participation Agreement, dated as of December 14, 2001, by and among GTECH, West Greenwich Technology Associates, L.P., Key Corporate Capital Inc., Post Office Square Funding Inc., Credit Lyonnais New York Branch, The Bank of Nova Scotia, and the Lenders described therein (incorporated by reference to Exhibit 10.24 of Holdings' 2002 10-K). 10.22 Second Amended and Restated Indenture of Lease, dated as of December 14, 2001, by and between West Greenwich Technology Associates, L.P., and GTECH (incorporated by reference to Exhibit 10.25 of Holdings' 2002 10-K). +10.23 Purchase Agreement, dated December 5, 2004, by and among Paul Gauselmann, Michael Gauselmann and GTECH Corporation. +10.24 Master Agreement, dated December 5, 2004, by and among Paul Gauselmann, Michael Gauselmann and GTECH Corporation. 10.25 1994 Stock Option Plan, as amended and restated (incorporated by reference to Exhibit 10.1 of Holdings' 10-Q for the quarterly period ended May 31, 1997).* 10.26 1996 Non-Employee Directors' Stock Option Plan (incorporated by reference to Exhibit 10.2 of Holdings' 10-Q for the quarterly period ended May 31, 1997).* 10.27 First Amendment to the 1996 Non-Employee Directors' Stock Option Plan (incorporated by reference to Exhibit 10.27 of Holdings' 2001 10-K).* 10.28 1997 Stock Option Plan (incorporated herein by reference to the Appendix of Holdings' 1997 Notice of Annual Meeting and Proxy Statement).* 10.29 Amendment to 1997 Stock Option Plan dated April 2, 2002 (incorporated by reference to Exhibit 10.32 of Holdings' 2002 10-K).* 10.30 Holdings' 1998 Non-Employee Directors' Stock Election Plan (incorporated by reference to Exhibit 4.2 to the Form S-8 of Holdings, Registration Number 333-5781). 10.31 Income Deferral Plan - 1998, as amended and restated (incorporated by reference to Exhibit 10.32 of Holdings' 2003 10-K).* 10.32 Holdings' 1998 Employee Stock Purchase Plan, as amended and restated as of November 1, 2001 (incorporated by reference to Exhibit 10.4 of Holdings' 10-Q for the quarterly period ended November 24, 2001).* 10.33 1999 Non-Employee Directors' Stock Option Plan (incorporated by reference to the Appendix of Holdings' 1999 Notice of Annual Meeting and Proxy Statement).* 10.34 First Amendment to the 1999 Non-Employee Directors' Stock Option Plan (incorporated by reference to Exhibit 10.32 of the Holdings' 2001 10-K).* 10.35 Trust Agreement, dated December 18, 1998, by and between Holdings and The Bank of New York, as Trustee, respecting the Income Deferral Plan - 1998 (incorporated by reference to Exhibit 10.1 of the Holdings' 10-Q for the quarterly period ended November 28, 1998).* 10.36 Holdings' 2000 Restricted Stock Plan and Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.4 of Holdings' 10-Q for the quarterly period ended August 26, 2000).* 10.37 Holdings' 2000 Omnibus Stock Option and Long-Term Incentive Plan (incorporated by reference to Holdings' Proxy Statement filed on September 22, 2000).* 10.38 Holdings' 2002 Omnibus Stock Option and Long-Term Incentive Plan (incorporated by reference to Holdings' Proxy Statement filed on June 21, 2002).* 10.39 Holdings' 2004 Employee Stock Purchase Plan (incorporated by reference to Appendix B of Holdings' Proxy Statement filed on June 25, 2004).* +10.40 Forms of Stock Option Agreement respecting awards under Holdings' plans. +10.41 Forms of Restricted Stock Agreement respecting awards under Holdings' plans. 10.42 Holdings' Management Stock Bonus Program (incorporated by reference to Exhibit 10.40 of Holdings' 2003 10-K).* 10.43 Senior Staff Officer Stock Ownership Plan, dated July 1, 2003 (incorporated by reference to Exhibit 10.1 of Holdings' 10-Q for the quarterly period ended May 24, 2003). 10.44 OEM Purchase Agreement by and between GTECH and TransAct Technologies Incorporated, dated July 2, 2002 (incorporated by reference to Exhibit 10.45 as Holdings' 2004 10-K). 10.45 OEM Purchase Agreement, by and between GTECH and Tokyo Magnetic Printing Co. Ltd, dated July 9, 1999 (incorporated by reference to Exhibit 10.46 as Holdings' 2004 10-K). 10.46 OEM Purchase Agreement, by and between GTECH and BCM Advanced Research, dated December 11, 2002 (incorporated by reference to Exhibit 10.47 as Holdings' 2004 10-K). +12.1 Computation of Ratio of Earnings to Fixed Charges. 14.1 The Company's Code of Conduct applicable to, among others, its Chief Executive Officer, Chief Financial and principal accounting officer(incorporated by reference to Exhibit 14.1 of Holdings' 2003 10-K). +21.1 Subsidiaries of the Company. +23.1 Consent of Ernst & Young, LLP. +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. ------------ + Filed herewith. * Indicates a management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. Certain instruments defining the rights of holders of long-term debt have not been filed pursuant to item 601(b)(4)(iii)(A) of Regulation SK. Copies of such instruments will be furnished to the Commission upon request. SIGNATURES Pursuant to the requirements of Section 13 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, in West Greenwich, Rhode Island, on April 27, 2005. GTECH HOLDINGS CORPORATION By: /s/ W. Bruce Turner ------------------------------------------------ W. Bruce Turner, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE ------------------------ ----------------------------------------------- -------------- /s/ W. Bruce Turner Chief Executive Officer (principal executive April 27, 2005 ------------------------ officer) and Director W. Bruce Turner /s/ Jaymin B. Patel Senior Vice President & Chief Financial Officer April 27, 2005 ------------------------ (principal financial officer) Jaymin B. Patel /s/ Robert J. Plourde Vice President, Corporate Controller, and Chief April 27, 2005 ------------------------ Accounting Officer (principal accounting Robert J. Plourde officer) /s/ Robert M. Dewey, Jr. Director, Chairman of the Board April 27, 2005 ------------------------ Robert M. Dewey, Jr. /s/ Christine M. Cournoyer Director April 27, 2005 -------------------------- Christine M. Cournoyer
SIGNATURE TITLE DATE -------------------------- ----------------------------------------------- -------------- /s/ Paget L. Alves Director April 27, 2005 -------------------------- Paget L. Alves /s/ Burnett W. Donoho Director April 27, 2005 -------------------------- Burnett W. Donoho /s/ The Rt. Hon. Director April 27, 2005 -------------------------- The Rt. Hon. Sir Jeremy Hanley KCMG /s/ Philip R. Lochner, Jr. Director April 27, 2005 -------------------------- Philip R. Lochner, Jr. /s/ James F. McCann Director April 27, 2005 -------------------------- James F. McCann /s/ Anthony Ruys Director April 27, 2005 -------------------------- Anthony Ruys
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
------------------------------------------------------------------------------------------------------------------------------------ COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ------------------------------------------------------------------------------------------------------------------------------------ Additions ------------------------- Balance at Charged Charged to Balance at beginning to costs other end of Description of year and expenses accounts Deductions year ------------------------------------------------------------ ---------- ------------ ---------- ---------- ---------- (Dollars in thousands) Valuation accounts deducted from assets to which they apply: Allowances for doubtful accounts $ 5,410 $ 254 $ (266) (a) $ (1,108) (d) $ 4,290 Allowances for liquidated damages 5,283 2,276 33 (2,559) (e) 5,033 Inventory allowances 8,120 3,407 (5) (5,694) (f) 5,828 Other 2,474 -- 148 -- 2,622 ---------- ------------ --------- ---------- ---------- Total Fiscal Year Ended February 26, 2005 $ 21,287 $ 5,937 $ (90) $ (9,361) $ 17,773 ========== ============ ========= ========== ========== Allowances for doubtful accounts $ 18,508 $ 227 $ 944 (a) $ (14,269) (d) $ 5,410 Allowances for liquidated damages 2,127 5,237 721 (2,802) (e) 5,283 Inventory allowances 14,561 (379) 6,349 (b) (12,411) (f) 8,120 Sales-type lease allowances 1,060 (1,072) -- 12 -- Other 1,300 -- 1,200 (c) (26) 2,474 ---------- ------------ --------- ---------- ---------- Total Fiscal Year Ended February 28, 2004 $ 37,556 $ 4,013 $ 9,214 $ (29,496) $ 21,287 ========== ============ ========= ========== ========== Allowances for doubtful accounts $ 18,773 $ 58 $ 5,528 (a) $ (5,851) (d) $ 18,508 Allowances for liquidated damages 1,614 4,587 807 (4,881) (e) 2,127 Inventory allowances 14,225 1,833 -- (1,497) (f) 14,561 Sales-type lease allowances 4,098 (566) 39 (2,511) (d) 1,060 Other 607 621 2,472 (c) (2,400) (e) 1,300 ---------- ------------ --------- ---------- ---------- Total Fiscal Year Ended February 22, 2003 $ 39,317 $ 6,533 $ 8,846 $ (17,140) $ 37,556 ========== ============ ========= ========== ==========
(a) Opening reserve balances associated with acquisitions or reserves for amounts billed to customers which were not recorded as revenues (b) Opening reserve balances associated with acquisitions (c) Reserves transferred from accrued expenses and/or other assets (d) Write-offs and recoveries of previous write-offs (e) Payments made directly to customers (f) Disposal of obsolete material