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SGMS > SEC Filings for SGMS > Form 10-Q on 8-May-2013All Recent SEC Filings

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Form 10-Q for SCIENTIFIC GAMES CORP


8-May-2013

Quarterly Report


Item 2. 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 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the fiscal year ended December 31, 2012 and the "Business" section included in our 2012 Annual Report on Form 10-K.

This MD&A also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and should be read in conjunction with the disclosures and information contained and referenced under "Forward-Looking Statements" included in this Quarterly Report on Form 10-Q.

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 technologies 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 business segments. See "Business Segments Results" below and Note 3 of the Notes to Consolidated Financial Statements included in this Quarterly Report on Form 10-Q 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 pursuant to which we agreed to acquire WMS Industries Inc., a leading supplier of gaming machines and interactive gaming systems and content ("WMS"), for $26.00 in cash per common share, for a total enterprise value of approximately $1,500.0 million. 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. We have filed an application for approval (or otherwise provided the required documentation or information), or have received confirmation that such approval is not required prior to the closing of the merger, in each of the jurisdictions where gaming regulatory approval is a condition to closing under the merger agreement. In March 2013, we received confirmation from the Federal Trade Commission of early termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 in connection with the merger, which satisfied the related closing condition. A meeting of WMS stockholders to consider and vote on the proposed merger has been scheduled for May 10, 2013.
In connection with the merger agreement, we entered into a commitment letter pursuant to which the lenders party thereto have agreed to provide the financing necessary to complete the transaction. The merger is not conditioned on our obtaining the proceeds of any financing, including the financing contemplated by the commitment letter. All indebtedness under our and WMS' current senior credit facilities is contemplated to be refinanced or repaid in connection with the financing contemplated by the commitment letter, which we anticipate will result in a loss on the early extinguishment of debt related to the write-off of deferred financing fees related to our existing senior credit facility. The merger agreement contains certain termination rights for both us and WMS and further provides that, in


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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 specified in the merger agreement or an order is issued pursuant to gaming laws prohibiting the closing of the merger, 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).
The transaction is expected to be completed by the end of 2013. However, no assurance can be given that the merger will be completed.
In connection with the pending merger, we incurred approximately $3.8 million in regulatory costs, professional fees and other expenses in the three months ended March 31, 2013, with additional transaction-related fees and expenses anticipated to be incurred throughout the balance of 2013.
For additional information regarding the pending merger with WMS and the contemplated 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 Securities and Exchange Commission ("SEC") on February 5, 2013, and the full text of the commitment letter, a copy of which is filed as exhibit 10.68 to our 2012 Annual Report on Form 10-K filed with the SEC on March 12, 2013. Printed Products
Our Printed Products segment is primarily comprised of our global instant ticket lottery business. We generate revenue from the manufacture and sale of instant tickets, as well as the provision of value-added services such as game design, sales and marketing support, specialty games and promotions, inventory management and warehousing and fulfillment services. We also provide lotteries with fully integrated instant ticket product management services under our cooperative service programs ("CSPs") to help them efficiently and effectively manage and support their operations to achieve higher retail sales and lower operating costs. Moreover, we provide licensed games, promotional entertainment and internet-based services to the lottery industry. Our U.S. instant ticket contracts typically have an initial term of three to five years and frequently include multiple renewal options for additional periods ranging from one to five years, which our customers have generally exercised in the past. We typically sell our instant lottery tickets for a price per thousand units ("PPK") or for a fee equal to a percentage of the retail sales of the instant lottery tickets ("POS"). Under our CSP contracts we are typically paid on a POS basis. Some of our international customers purchase instant lottery tickets periodically rather than through multi-year supply contracts.
We consider retail sales of instant tickets to 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 increased 2.0% for the three months ended March 31, 2013 compared to the prior year period, driven by strong performance in larger states. The year-over-year change in retail sales reflected challenging comparisons with the strong retail sales levels in the prior-year period. 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. On January 30, 2013, we entered into a new license agreement with Hasbro International, Inc. ("Hasbro") for the use of certain of Hasbro's licensed properties through December 31, 2016.
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. We commenced new Properties Plus programs with four lotteries during 2012 and had 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 other lotteries regarding these programs, both in the U.S. and internationally.
We are the primary supplier of instant lottery tickets for Lotterie Nazionali S.r.l. ("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. The concession has an initial term of nine years (subject to a performance evaluation


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during the fifth year) and could be extended by the Italian lottery authority for an additional nine years. 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 three months ended March 31, 2013 declined by approximately 2.8% compared to the same period in 2012, which we believe was due in part to a decline in consumer spending related to difficult economic conditions in Italy.
Northstar Lottery Group, LLC ("Northstar Illinois"), in which we have a 20% equity investment, commenced operations as the private manager of the Illinois lottery on July 1, 2011 under a private management agreement ("PMA") with the State of Illinois. Northstar Illinois is 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 Illinois will be responsible for payments to the State to the extent such targets are not achieved, subject to a similar cap. 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 the ability of Northstar Illinois to receive incentive compensation payments. Additional information regarding our equity investment in Northstar Illinois and the terms of the incentive compensation and shortfall payments is included in Note 10 of the Notes to Consolidated Financial Statements in our 2012 Annual Report on Form 10-K.
In November 2012, an arbitrator determined that Northstar Illinois 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 Quarterly Report on Form 10-Q, it is unclear if these adjusted net income targets are final or subject to further review or adjustment. In March 2013, the State notified Northstar Illinois that the State had calculated net income for the lottery's 2012 fiscal year to be $756.8 million, which would result in a shortfall payment of $20.1 million payable by Northstar Illinois to the State. We understand that the State's calculation of net income was based on unaudited information and is substantially lower than Northstar Illinois' calculation of net income. We understand that Northstar Illinois intends to seek to resolve the variance under the dispute resolution process contemplated by the PMA. Accordingly, as of the date of this Quarterly Report on Form 10-Q, Northstar Illinois is unable to estimate, and therefore has not recorded, any amounts in respect of annual incentive compensation or net income shortfall payments.

As U.S. and international jurisdictions increasingly look toward 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 is conducted by a third party, similar to the PMA model in Illinois. To the extent any of our lottery customers enters 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. In 2012, the Indiana lottery awarded a private management agreement to one of our competitors. On March 25, 2013, we entered into an instant ticket lottery contract for five years with the manager of the Indiana lottery, which contract went into effect April 2013 following the expiration of the instant ticket lottery contract we had with the Indiana lottery. In December 2012, we formed Northstar New Jersey Lottery Group, a joint venture with GTECH and a subsidiary of the administrator of the Ontario Municipal Employees Retirement System (OMERS) ("Northstar New Jersey"), to bid for a 15-year contract to provide marketing and sales services for the New Jersey lottery. In April 2013, the State issued a notice of intent to award the contract to Northstar New Jersey. The contract award is subject to a protest by a union that represents certain of the lottery workers. If and when the services agreement is executed, our joint venture entity will be obligated to pay an upfront fee of $120.0 million to the State. Under the terms of the contemplated joint venture agreement, we will own a 17.69% equity interest in the joint venture and will therefore be responsible for approximately $21.2 million, or 17.69%, of the upfront fee payable to the State, plus our pro rata share of initial working capital requirements of the joint venture. We expect to serve as the primary instant ticket supplier during the term of the services agreement and have a 30% economic interest (and be responsible for 30% of the capital requirements) associated with the supply of instant lottery tickets, lottery systems and services, and potentially a player loyalty and rewards program to the joint venture.
On December 12, 2012, the Hellenic Republic Asset Development Fund provisionally awarded a 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 and certain traditional lotteries in Greece. The consortium is principally comprised of OPAP S.A., Scientific Games and Intralot, S.A. In April 2013, the provisional award of the concession was approved by the Greek court of auditors and the related protest period subsequently expired. Operations under the new concession are subject to Greek parliamentary approval and approval of the Greek competition authority. 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 make 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 Greek state equal to a percentage of gross gaming revenue. According to third-party data, in 2011, OPAP generated €4.4 billion in total lottery retail


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sales in Greece, or approximately €386 on a per capita basis, 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. In May, a strategic alliance we formed with a Panamanian company entered into a 10-year contract with the Panama lottery to supply instant tickets under a cooperative services program until 2023. We are the exclusive supplier of instant tickets and services to the consortium for the term of the contract.

Lottery Systems

We are a leading provider of customized computer software, software support, and equipment and data communication services to lotteries. In the U.S., we typically provide the necessary equipment, software and maintenance services pursuant to long-term contracts that typically have an initial term of at least five years and under which we are generally paid a fee equal to a percentage of the lottery's total retail sales. Our U.S. contracts typically contain multiple renewal options, which our customers have generally exercised in the past. Internationally, we typically sell point-of-sale terminals and/or computer software to lottery authorities and may provide ongoing fee-based systems and software support services. In addition, we are the exclusive instant ticket validation network provider to the China Sports Lottery ("CSL").
We believe that retail sales of draw games is 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 contracts, the impact of changes in our customer contracts or other factors. 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, on our service revenue in any given period. The industry experienced the largest Mega Millions jackpot in history ($656 million) during the three months ended March 31, 2012. There were no Mega Millions or Powerball jackpots of comparable size during the three months ended March 31, 2013.

Based on third-party data, our Lottery Systems customers' total draw game retail sales in the U.S. decreased 14.9% for the three months ended March 31, 2013 compared to the same period in 2012. Our Lottery Systems service revenue in the U.S. decreased 7.9% for the three months ended March 31, 2013 compared to the prior-year period due in part to the size of a Mega Millions jackpots in the respective period. 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 sales of equipment that are non-recurring in nature.

Our lottery systems contract with the Indiana lottery was terminated in connection with the award of a private management agreement to another vendor. In January 2013, we entered into an agreement with the private manager of the Indiana lottery to provide our existing lottery systems equipment and related services through August 2016, which contract commenced in April 2013. In February 2013, we executed a five-year extension of our lottery systems contract with the Connecticut lottery. In March 2013, we executed a contract with the Oklahoma Lottery to continue supplying instant tickets and lottery services for an initial period of one year subject to nine one-year contract extension options held by the lottery. In May 2013, a strategic alliance, principally comprised of us and 888 Holdings Public Limited Company, as the primary vendor, and Williams Interactive LLC (a wholly owned subsidiary of WMS), as the game content vendor, was awarded a contract to provide internet gaming systems and services to the Delaware Lottery for an initial period of five years, subject to four one-year contract extensions held by the lottery.

We are the exclusive instant ticket validation network provider to the CSL under an agreement that expires in January 2016. Under the terms of this agreement, the POS rate we receive decreased by 0.1% in January 2012 and is scheduled to decrease by an additional 0.1% in January 2014. 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 have declined. For the three months ended March 31, 2013, instant ticket retail sales of the CSL decreased approximately 12.5% compared to the same period in 2012. We remain focused on improving retail sales 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.

Gaming
We are a leading supplier of server-based gaming terminals and systems and game content primarily to bookmakers that operate licensed betting offices ("LBOs") in the U.K. and to gaming operators outside the U.K. We also supply gaming terminals, systems and game content to bingo halls and arcades in the U.K. and continental Europe. We provide many of our Gaming customers with turnkey offerings, which typically include gaming terminals, remote management of game content and


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management information, central computer systems, secure data communication and field support services. We develop our own game content and supplement our offerings with content from third parties. We also provide interactive gaming products and services including development and marketing of digital content, products, services and end-to-end solutions that address interactive, social, casual and mobile gaming opportunities.
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 decreased approximately 1.2% for the three months ended March 31, 2013 compared to the same period in 2012, which we believe is due in part to challenging economic conditions and inclement weather that resulted in reduced LBO activity. Our gross win per terminal per day showed sequential improvement in each of the three months ended March 31, 2013. We had an installed base of approximately 21,500 and 22,900 LBO gaming terminals in the U.K. as of March 31, 2013 and 2012, respectively. The decrease in our LBO installed base is primarily a result of the expiration of our contract with William Hill PLC ("William Hill"), a major U.K. bookmaker, in early 2012. The removal of the gaming terminals associated with such contract negatively impacted our results of operations for the three months ended March 31, 2013.

We are also a leading supplier of gaming content, platforms and systems to gaming operators in the U.K. and continental Europe, LBOs, bingo halls and arcades. We have an expansive library of gaming titles and properties, as well as an existing base of business in interactive gaming in which game content is made available through internet, mobile and other digital delivery channels. We had an installed base of approximately 2,600 related to our bingo hall and arcade business as of March 31, 2013 and 5,800 gaming terminals related to our U.K. pub, bingo hall and arcade business as of March 31, 2012. In January 2012, following a comprehensive strategic review, we announced our exit from the amusement with prize ("AWP") analog terminal business of Barcrest Group Limited ("Barcrest"), which we acquired in October 2011, in order to focus our game design and other resources solely on our digital server-based supply model. We also reorganized our pub business to more effectively capitalize on the Barcrest acquisition. On March 25, 2013, we sold our installed base of gaming terminals in our pub business to a third party and entered into a transitional services agreement for approximately six months. The sale of the gaming terminals decreased our installed base of gaming terminals but did not have a material impact on our results of operations for the three months ended March 31, 2013.

We continue to seek to expand our server-based gaming terminal business outside the U.K., with current deployments in the Caribbean, Czech Republic, Mexico and Puerto Rico. We had an installed base of approximately 5,600 and 5,900 gaming terminals outside of the U.K. as of March 31, 2013 and 2012, respectively. In April 2012, approximately 1,400 video lottery terminals operated by SNAI in Italy and supplied by Barcrest were deactivated following the erroneous printing of what appeared to be winning jackpot and other tickets. The deactivation of the terminals negatively impacted the Gaming results of operations for the three months ended March 31, 2013. See "Legal Proceedings" in Part II, Item 1 of this Quarterly Report on Form 10-Q for further information. We are recording the revenue from our gaming contract with a customer in Puerto Rico on a cost recovery (cash basis) method, which negatively impacted our Gaming results of operations for the three months ended March 31, 2013 compared to the prior-year period.
In late 2010, the U.K. government announced its intention to change the taxation of gaming machines by replacing the currently applicable amusement machine license duty and the value-added tax with a new machine games duty, or MGD, based on the gross win generated by a gaming machine. In a budget statement issued in March 2012, the U.K. government announced a standard MGD rate of 20% on gross win, effective February 1, 2013. These tax changes may negatively impact our gaming machine customers' businesses and, therefore, could negatively impact our business in 2013.
Competition and Foreign Currency Risk
We believe we are likely to continue to experience a highly competitive environment for U.S. and international customer contracts in connection with bids, re-bids, extensions and renewals, which could lead to loss of contracts, rate or volume reductions and additional service requirements in contracts that we win or retain. See the table under "Business - Contract Procurement" in Item 1 of our 2012 Annual Report on Form 10-K for additional information regarding our customer contracts, including when they may become subject to re-bid, extension, or renewal. Our strategy to mitigate these industry trends includes working with our customers to grow their sales through a variety of . . .

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