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SGMS > SEC Filings for SGMS > Form 10-K on 12-Mar-2013All Recent SEC Filings

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Form 10-K for SCIENTIFIC GAMES CORP


12-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management's Discussion and Analysis ("MD&A") is intended to enhance the reader's understanding of our operations and current business environment. This MD&A should be read in conjunction with the description of our business (Item 1 of this Annual Report on Form 10-K) and our Consolidated Financial Statements and Notes thereto (Item 8 of this Annual Report on Form 10-K).
This MD&A also contains forward-looking statements and should be read in conjunction with the disclosures and information contained under "Forward-Looking Statements" at the beginning of this Annual Report on Form 10-K and "Risk Factors" (Item 1A of this Annual Report on Form 10-K).
As used in this MD&A, the terms "we," "us," "our" and the "Company" mean Scientific Games Corporation together with its consolidated subsidiaries. Business Overview
General
We are a global leader in providing customized, end-to-end gaming solutions to lottery and gaming organizations worldwide. Our integrated array of products and services includes instant lottery games, lottery gaming systems, terminals and services, and internet applications, as well as server-based gaming terminals and associated gaming control systems. We also gain access to technology and pursue global expansion through strategic supply agreements, acquisitions and equity investments.
We report our operations in three business segments: Printed Products, Lottery Systems and Gaming. Our revenue is classified as instant tickets revenue, service revenue and sales revenue. Instant tickets revenue includes revenue related to our instant lottery ticket fulfillment and services businesses, including our brand licensing and Properties Plus businesses. Revenue generated from our sales of lottery systems, terminals, gaming terminals, gaming content and phone cards, which sales are typically non-recurring in nature and not subject to multi-year supply agreements, is categorized as sales revenue. All other revenue generated from Lottery Systems (including revenue from the validation of instant tickets and other systems management contracts) and Gaming is classified as service revenue. Certain unallocated expenses managed at the corporate level, comprised primarily of general and administrative costs and other income and expense are not allocated to our reportable segments. See "Business Segment Results" below and Note 2 (Business and Geographic Segments) to the Consolidated Financial Statements in this Annual Report on Form 10-K for additional business segment information.
The discussion below highlights certain key drivers of our business and certain known trends, demands, commitments, events and uncertainties that have affected our recent, and may affect our future, financial and operating performance.

Pending Merger with WMS
On January 30, 2013, we entered into a merger agreement with WMS, SGI, and SG California Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Scientific Games ("Merger Sub").
The merger agreement provides for the merger of Merger Sub with and into WMS, with WMS surviving the merger as a wholly owned subsidiary of Scientific Games. In the merger, each outstanding share of common stock, par value $0.50 per share, of WMS, other than any dissenting shares, restricted shares, shares held by Scientific Games or Merger Sub and WMS treasury shares, will be cancelled and converted into the right to receive $26.00 in cash, without interest (the "Merger Consideration").
At the effective time of the merger, each outstanding WMS stock option granted prior to January 30, 2013 will be cancelled in exchange for the right of the holder to receive a lump sum cash payment equal to the number of shares underlying the WMS stock option multiplied by the excess of the Merger Consideration over the exercise price, if any. In addition, each outstanding award of WMS restricted shares, restricted stock units and phantom units will be cancelled as of the effective time, in exchange for the right of the holder to receive a lump sum cash payment equal to the Merger Consideration multiplied by the number of shares underlying each award, except for certain equity awards that are permitted to be granted by WMS following January 30, 2013 (including employee stock options), which will be converted into equivalent awards of Scientific Games using a customary exchange ratio of WMS' stock price to Scientific Games' stock price on the closing date. As of the effective time, each outstanding award of WMS performance units will be cancelled in exchange for the right of the holder to receive a lump sum cash payment equal to the Merger Consideration multiplied by the number of shares underlying the performance


units at the applicable payout percentage, which will be 100% unless the relevant performance targets are met or exceeded as of the effective time, in which case the payout percentage will be determined based on actual performance. The closing of the merger is subject to customary closing conditions, including approval of the merger by WMS stockholders and approvals by various regulatory authorities. The parties have agreed that receipt of gaming approvals from approximately 50 jurisdictions is a condition to closing of the merger, provided that receipt of gaming approvals from approximately 30 of these jurisdictions will cease to be a condition to closing from and after October 31, 2013. We believe that the approximately 50 jurisdictions include the material jurisdictions from which gaming approvals will be required prior to closing. We believe that the approximately 20 jurisdictions with respect to which approvals are a condition to any closing include the material jurisdictions where we anticipate longer lead times for obtaining approvals. Scientific Games is entitled to a 20 consecutive business day financing marketing period if all gaming approvals are received prior to October 31, 2013.
Under the merger agreement, WMS may not initiate, solicit or knowingly encourage competing proposals or participate in any discussions or negotiations regarding alternative business combination transactions.
The merger agreement contains certain termination rights for both Scientific Games and WMS and further provides that, in connection with termination of the merger agreement under specified circumstances, (i) we may be required to pay to WMS a termination fee of $100.0 million if all the conditions to closing have been met and the merger is not consummated because of a breach by our lenders of their obligations to finance the transaction, (ii) we may be required to pay to WMS a termination fee of $80.0 million if we are unable to obtain the gaming approvals that are conditions to closing prior to the termination date, and
(iii) WMS may be required to pay to us a termination fee of $44.3 million under specified circumstances, including, but not limited to, a change in the WMS board's recommendation of the merger or termination of the merger agreement by WMS to enter into a written definitive agreement for a "superior proposal" (as defined in the merger agreement). In connection with the merger agreement, Scientific Games and SGI entered into a commitment letter with Bank of America, N.A., Credit Suisse AG and UBS AG, Stamford Branch and certain of their respective affiliates, which was subsequently amended and restated on February 19, 2013 to add J.P. Morgan Securities LLC, the Royal Bank of Scotland, Deutsche Bank AG New York Branch, Goldman Sachs Bank USA and HSBC Securities (USA) Inc. and certain of their respective affiliates as additional commitment parties. Pursuant to the commitment letter, the commitment parties have agreed to provide the financing necessary to fund the consideration to be paid pursuant to the terms of the merger agreement (the "Debt Commitment Financing"). The Debt Commitment Financing is anticipated to consist of a senior secured first-lien term loan facility in a total principal amount of $2,300.0 million and a senior secured first-lien revolving credit facility in a total principal amount of $300.0 million. The funding of the Debt Commitment Financing is contingent on the satisfaction of certain conditions set forth in the commitment letter. The merger is not conditioned on our obtaining the proceeds of any financing, including the financing contemplated by the commitment letter. In connection with the merger, we currently expect to incur regulatory costs, professional fees and other expenses totaling approximately $4.0 million to $6.0 million in the first quarter of 2013, with additional transaction-related fees and expenses anticipated to be incurred throughout the balance of 2013. For further information regarding this pending acquisition and the Debt Commitment Financing, please see the full text of the merger agreement, a copy of which is filed as exhibit 2.1 to our Current Report on Form 8-K filed with the SEC on February 5, 2013, and the full text of the commitment letter, a copy of which is filed as exhibit 10.68 to this Annual Report on Form 10-K. Printed Products
Retail sales of instant tickets can be a key performance indicator of our instant ticket revenue, although there may not always be a direct correlation between retail sales and our instant ticket revenue due to the type of contract (e.g., PPK versus POS or CSP contracts), the impact of changes in our customer contracts, the performance of our licensed properties business or other factors. Based on third-party data, our customers' total instant ticket lottery retail sales in the U.S. increased 9.1% for the year ended December 31, 2012 compared to 2011. Most of our U.S. customers reported year-over-year growth in retail sales of instant lottery tickets, which we believe was driven by a variety of factors, including product innovation, better instant ticket product management, prize payout increases, lottery private management and sales of higher price-point tickets. We believe that, as of the date of this Annual Report on Form 10-K, U.S. instant ticket retail sales during the first quarter of 2013 appear to be soft relative to the first quarter of 2012, when U.S. retail sales of instant tickets grew over 12%.
Our licensed game contracts are generally game-specific and therefore short-term and non-recurring. Our instant ticket revenue may be negatively impacted to the extent we are unable to continue to win licensed game-specific or multi-state game contracts. There has been increased interest within the lottery industry in player loyalty programs, which we believe may result in further growth opportunities for our Properties Plus loyalty program, which features players clubs, reward programs, second chance promotional websites and interactive games. During 2012, we commenced new Properties Plus programs for four


lotteries for a total of seven active programs as of December 31, 2012. In February 2013, the Maryland lottery signed an agreement with us for a Properties Plus program and we are in active discussions with several other lotteries regarding these programs, both in the U.S. and internationally.
We are the primary supplier of instant lottery tickets for LNS, in which we have a 20% equity investment, which was awarded the concession to be the exclusive operator of the Italian Gratta e Vinci instant ticket lottery beginning on October 1, 2010. Over the life of the concession, we expect that we will supply no less than 80% of LNS' instant ticket production requirements. Retail sales for LNS for the year ended December 31, 2012 declined by approximately 3.8% compared to 2011, which we believe was due in part to a decline in consumer spending related to difficult economic conditions and tax increases in Italy. We also faced challenging year-over-year retail sales comparisons for the year ended December 31, 2012 in light of the strong retail sales performance of the Italian instant ticket lottery during the prior year.
Northstar, in which we have a 20% equity investment, commenced operations as the private manager of the Illinois lottery on July 1, 2011 under the PMA with the State of Illinois. Under our CSP agreement with Northstar, we are responsible for the design, development, manufacturing, warehousing and distribution of instant lottery tickets and are compensated based on a percentage of retail sales. Illinois lottery instant ticket sales increased approximately 22.6% for the year ended December 31, 2012. Our POS-based instant lottery ticket revenue for the year ended December 31, 2012 reflected our CSP agreement with Northstar which commenced on July 1, 2011.
Northstar is entitled to reimbursement on a monthly basis for most of its operating expenses under the PMA, although certain expenses of Northstar associated with managing the lottery are not reimbursable. Northstar is also entitled to receive annual incentive compensation payments from the State to the extent it is successful in increasing the lottery's net income (as defined in the PMA) above specified target levels, subject to a cap of 5% of the applicable year's net income. Northstar will be responsible for payments to the State to the extent such targets are not achieved, subject to a similar cap. The lottery net income targets set forth in Northstar's successful bid for the PMA were $851 million, $950 million, $980 million, $986 million and $1 billion for the five fiscal years ending June 30, 2012, 2013, 2014, 2015 and 2016, respectively, representing a cumulative growth rate in lottery net income over such time period of approximately 49%.

These net income target levels are subject to upward or downward adjustment under certain circumstances in accordance with the terms of the PMA. Northstar may seek downward adjustments to the net income targets in the event certain actions of the State (or the federal government) have a material adverse effect on the lottery's net income and Northstar's ability to receive incentive compensation payments. On November 6, 2012, an arbitrator determined that Northstar is entitled to a $28.4 million downward adjustment to the net income target for the lottery's 2012 fiscal year and a $2.9 million downward adjustment to the net income target for the lottery's 2013 fiscal year. We understand that the State has objected to the arbitrator's determination. As of the date of this Annual Report on Form 10-K, it is unclear if these adjusted net income targets are final or subject to further review or adjustment. Accordingly, as of the date of this Annual Report on Form 10-K, Northstar is unable to estimate, and therefore has not recorded, any amounts in respect of annual incentive compensation or net income shortfall payments for the year ended December 31, 2012.
As U.S. and international jurisdictions increasingly look towards lottery and gaming as a source to grow revenue, we believe there will be continued interest in pursuing an outsourcing model whereby the day-to-day management of lotteries are conducted by a third party, similar to the PMA model in Illinois. To the extent any of our lottery customers enter into a private management agreement, such lottery customer or the private manager may terminate our existing contract(s) with the lottery customer as part of the transition to the private management model. The Indiana lottery recently awarded a private management agreement to one of our competitors. We expect to enter into an instant ticket lottery contract with the manager of the Indiana lottery that is expected to commence in April 2013 following the expiration of our current instant ticket lottery contract with the Indiana lottery.
We recently assisted the Commonwealth of Pennsylvania in its potential procurement of a private management agreement for the Pennsylvania lottery. In light of our role in the process, we did not bid for the private management agreement in Pennsylvania. On January 11, 2013, the Commonwealth issued a notice of award of the private management agreement to a bidder. On February 14, 2013, the Pennsylvania Attorney General rejected the agreement as unlawful. We cannot be certain as to the status of the private management agreement or what the ultimate resolution of this privatization effort will be at this time. Under our current contracts with the Pennsylvania lottery, we are the exclusive provider of instant lottery tickets and lottery systems and services in Pennsylvania through August 2015 and December 2014, respectively.
In December 2012, we formed Northstar New Jersey with GTECH and OMERS to bid to be the private manager for the New Jersey Lottery for a 15-year term. If Northstar New Jersey is selected as the private manager, we expect to own a 17.69% equity interest in the joint venture entity that will execute the private management agreement.


Following a strategic review of our global instant lottery ticket business, we commenced a reorganization plan on April 18, 2012 to cease all printing and finishing activities at our Australia facility, and during the second half of 2012 we migrated printing for customers in this region to our other manufacturing facilities. We recorded approximately $5.9 million of employee termination and other restructuring costs associated with the reorganization for the year ended December 31, 2012. Other restructuring costs include approximately $1.3 million resulting from vacating our facility. In addition, we recorded approximately $3.4 million of accelerated depreciation for equipment related to this reorganization. We do not expect to incur additional material costs or accelerated depreciation related to this reorganization. On June 8, 2012, we acquired 100% of the equity interests of Provoloto for approximately $9.7 million, subject to certain adjustments, including an estimated earn-out payable to the sellers of approximately $2.0 million contingent on the future performance of the acquired business. Provoloto develops and distributes instant lottery tickets and manages instant ticket lotteries for Mexican charities. We expect this acquisition to strengthen our presence in Latin America and create a platform for further expansion in the region. The operating results of Provoloto have been included in our Printed Products segment and have been consolidated in our results of operations since the date of acquisition. The acquisition did not have a material impact on our results of operations in 2012.
On December 12, 2012, the Hellenic Republic Asset Development Fund provisionally awarded the consortium in which we own a 16.5% equity interest a 12-year concession for the exclusive rights to the production, operation and management of instant ticket lotteries in Greece. The consortium is principally comprised of OPAP S.A., Scientific Games and Intralot. The concession will cover current and future instant lotteries which are conducted using physical tickets, as well as internet sales of physical tickets. Operations under the new concession are subject to various regulatory approvals and Greek parliamentary approval. We will be responsible for providing instant lottery ticket marketing services to the lotteries and expect to enter into a supply agreement for the exclusive provision of all instant ticket production and game design services to the consortium. If the award is approved, the consortium will pay an upfront payment of €190 million, of which our portion will be €31.4 million, and will be responsible for a monthly fee to the lotteries equal to a percentage of gross gaming revenue. According to third-party data, in 2011, OPAP generated €4.4 billion in total lottery retail sales in Greece, representing approximately €386 in per capita sales, making it the third largest lottery in the world in terms of per capita sales based on third party data. The instant ticket lottery has been inactive since 2003.
Lottery Systems
Retail sales of draw games can be a key performance indicator of our lottery systems service revenue, although there may not always be a direct correlation between retail sales and our lottery systems revenue due to the terms of contract, the impact of changes in our customer contracts or other factors. Based on third-party data, our Lottery Systems customers' total draw game retail sales in the U.S. increased 9.7% for the year ended December 31, 2012 compared to 2011. Our Lottery Systems service revenue in the U.S. increased 10.1% for the year ended December 31, 2012 compared to 2011 due in part to this improvement in U.S. retail sales. The level of jackpots of the Powerball and Mega Millions multi-state draw lottery games have an impact on U.S. retail sales, and therefore, our service revenue in any given period. We believe that, as of the date of this Annual Report on Form 10-K, U.S. draw game retail sales during the first quarter of 2013 appear to be soft relative to the first quarter of 2012, when U.S. retail sales of draw games grew nearly 16%. In 2011, U.S. lottery directors authorized certain changes to the Powerball game, including an increase in the ticket price to $2, which went into effect on January 15, 2012. The industry experienced the largest Powerball jackpot in history ($587.5 million) and the largest Mega Millions jackpot in history ($656 million) during the year ended December 31, 2012. Our Lottery Systems service revenue is also impacted by retail sales of instant lottery tickets where we provide instant lottery ticket validation services as part of a lottery systems contract. Our Lottery Systems sales revenue primarily relates to one-time sales of equipment and is non-recurring in nature.

In June 2012, we executed a four-year extension of our contract to provide lottery systems and services, along with instant tickets, to Loteria Electronica in Puerto Rico. In June 2012, we executed a one-year extension of our lottery systems contract with the Maine lottery. In August 2012, Maine issued a lottery systems and instant lottery ticket RFP that we responded to in October 2012. We understand the State is still evaluating the bids it received. The Indiana lottery recently awarded a private management agreement to one of our competitors. We expect that our lottery systems contract with the Indiana lottery will be terminated in connection with the commencement of the private management model in Indiana. On January 11, 2013, we entered into an agreement with the new manager of the Indiana lottery to provide existing lottery systems equipment and services through August 2016 which is expected to commence in April 2013. On February 18, 2013, we executed a five-year extension of our lottery systems contract with the Connecticut lottery.

We are the exclusive instant ticket validation network provider to the CSL. The POS rate we receive under our China instant ticket validation contract decreased by 0.1% in January 2012 and is scheduled to decrease by an additional 0.1% in January 2014, in accordance with the contract.


In China, we have seen a recent decline in our instant ticket validation revenue and our joint venture's instant ticket printing revenue as instant ticket retail sales of the CSL decreased approximately 10.0% for the year ended December 31, 2012 compared to 2011. We continue to believe there is sustained consumer demand for lottery products in China, as retail sales of the entire lottery segment grew by 18% in 2012 compared to 2011, but that competition from other lottery products is impacting instant ticket sales. We remain focused on improving sales trends by expanding the lottery retailer network and increasing our involvement in the game selection process. We believe it will take some time for any such actions to take effect. To the extent we are not able to successfully implement these remedial actions and offset our CSL contract rate reductions by retail sales growth, our revenue and profitability may be adversely affected.

On April 7, 2012, we signed a five-year agreement in China to provide sales and distribution management services to the Hubei Sports Lottery. The agreement is similar to the CSP contracts we have with many of our North American and European customers. We expect that these services will assist the Hubei Sports Lottery in achieving higher retail sales and lower operating costs. We expect operations under the contract to commence in 2013.

We entered into a contract, effective in December 2011, to design, implement and administer our AEGIS-Video™ Central Management and Control System (CMCS) for the Illinois Gaming Board. Under the terms of the contract, we will provide real-time communication and control between every licensed video gaming terminal in the State of Illinois, as well as day-to-day management of the CMCS throughout the State. The contract was awarded through a competitive procurement process, has an initial term of six years and may be extended by mutual agreement for up to four additional years. Operations under the contract commenced on October 9, 2012.
On July 19, 2012, we acquired substantially all of the assets of Parspro for approximately $11.8 million. Parspro is a provider of sports betting systems and related products via point of sale terminals, the internet and mobile devices. The acquired assets include technology that we expect to integrate into our Lottery Systems business and our interactive game platform as part of an expanded service offering to lottery customers. The operating results of Parspro have been included in our Lottery Systems segment and have been consolidated in our results of operations since the date of acquisition. The acquisition did not have a material impact on our results of operations for the year ended December 31, 2012.

Gaming

In our U.K. gaming terminal business, our compensation is typically based on gross win (i.e., amount bet less player winnings) generated by our gaming terminals (subject to certain adjustments as may be specified in a particular contract, including adjustments for taxes and other fees). Our Gaming service revenue is therefore impacted by the size of our installed gaming terminal base and the gross win generated by our terminals. Our Gaming sales revenue is generally non-recurring in nature.

Our U.K. LBO contracts generally have initial terms of two to four years with potential extensions. Our gross win per terminal per day increased approximately 5.0% for the year ended December 31, 2012 compared to 2011. We had an installed base of approximately 21,200 and 23,100 LBO gaming terminals in the U.K. as of December 31, 2012 and 2011, respectively. In 2011, we completed the migration of our server-based gaming terminals in the U.K. to a new back-end technology platform and migrated the majority of our server-based gaming terminals outside the U.K. to this technology during 2012. As of June 30, 2011, we completed the installation of approximately 8,000 gaming terminals for the entire Ladbrokes Betting and Gaming Ltd. LBO estate in accordance with the contract awarded to us in 2010. In January 2012, William Hill, a U.K. bookmaker, awarded a contract for the exclusive supply of gaming terminals to its entire LBO estate to one of our competitors. Our contract with William Hill expired in March 2013, resulting in a decrease in deployed gaming terminals of approximately 1,900. The loss of this contract impacted our installed gaming terminal base and our results of operations in 2012. On October 5, 2012, we extended an agreement to continue as the exclusive provider of gaming terminals for Gala Coral, a major U.K. bookmaker, through December 31, 2017.

On June 7, 2012, we acquired ADS for £3.5 million, subject to certain adjustments. ADS provides maintenance and other services for LBOs in the U.K. We have integrated the acquisition into our existing Gaming business and we expect that the acquisition will allow us to expand the services we provide to our LBO customers. The operating results of ADS have been included in our Gaming segment and have been consolidated in our results of operations since the date of acquisition. The acquisition did not have a material impact on our results of operations for the year ended December 31, 2012.
On September 23, 2011, we completed the acquisition of Barcrest, a leading supplier of gaming content, platforms and systems to gaming operators in the U.K. and continental Europe, including pubs, LBOs, bingo halls and arcades. The . . .

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