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Shares of Scientific Games Corp (SGMS) are trading with modest gains of 6.2% so far in 2013, after having witnessed quite some volatility. The global supplier of solutions to lottery and gaming organizations announced the acquisition of WMS Industries (WMS) on the last day of January.

The Deal

Scientific Games Corporation announced that it has agreed to acquire WMS Industries, the second largest machine supplier of the country according to its acquisition presentation.

Scientific Games will pay $26.00 per share in cash for each outstanding share of WMS, valuing the equity of the firm at $1.55 billion. WMS operates with $85 million in debt and $55 million in cash, for a net debt position of $30 million, for a total enterprise value of $1.58 billion.

The offer is very rich given that shares of WMS closed at $16.37 on the 30th of January. The $26 offer represents a 58.8% premium compared to the closing price. At the moment shares are trading around $25, leaving another 4% potential return on the table.

As a result of the deal, Scientific Games expects to diversify the revenue base, expand margins and propel growth opportunities. Combined both firms will be a worldwide leader in the lottery & gaming hardware and software market, with over 40,000 participation-based machines.

The deal is subject to customary closing conditions including WMS shareholder approval, US antitrust approval and gaming regulatory approval. The company expects to close the deal by the end of the year.

Value Creation

WMS Industries generated $690 million in sales for the year ending on June 2012. The company net earned $64.1 million for the year. As such the company is valued at 2.2 times annual revenues and approximately 24 times annual earnings. WMS is valued at 6.0 times trailing annual adjusted EBITDA according to the presentation of Scientific Games, or 4.4 times EBITDA when factoring in the expected run-rate of synergies.

The company expects to achieve significant synergies as a result of the deal. Scientific anticipates to achieve $90 million in annual cost savings and another $20 million in cash flow savings as a result of lower capital expenditures needs. Based on the existing profitability of WMS and the significant synergies, operating cash flows could in total increase by approximately $160 million. This calculation excludes the increased financing costs of approximately $75 million per annum, assuming the company can finance the deal at rates of 5%.

Valuation

Scientific Games Corp ended its third quarter of 2012 with $136.0 million in cash and equivalents, and $1.47 billion in short and long term debt, for a net debt position of $1.34 billion. The company has a 100% commitment for debt financing to be used to finance the deal and refinance senior credit facilities.

The firm generated total revenues of $691.4 million for the first nine months of the year. The company reported a $37.9 million net loss as a result of high interest payments on its debt position and high income taxes. The company is on track to report annual revenues of $950 million on which it is expected to report an annual loss.

The market currently values Scientific Games Corporation at $784 million, which values the firm at 0.83 times annual revenues.

Scientific Games does not pay a dividend at the moment.

Some Historical Perspective

Shares of Scientific Games Corporation have gradually lost ground over the past year. Shares have fallen from $12 at the start of 2012 to lows of $6 by the end of summer. From that point in time, shares have regained half of their ground, trading around $9 per share.

Despite the rebound, shares are still trading some 75% lower from their highs of $40 in 2006 and 2007. Between 2008 and 2011, the company has seen its revenues fall from $1.12 billion to $878 million, down more than 20%. The company has failed to achieve profitability on the back of lower revenues and a high debt load.

Investment Thesis

Shareholders of Scientific Games initially reacted very favorable to the deal as shares jumped up almost 20% in reaction to the deal, reaching highs around $10.70 on the 31th of January. Shares quickly gave up ground hitting $8.50 at the start of February before recovering to $9 as a result of the deal.

Combined both firms have excellent operations despite the long term challenges in the industry. Both firms generate roughly $1.6 billion in total revenues and are expected to report a modest profit on a pro-forma basis given WMS's profits and Scientific Games' losses. Factoring in $100 million in annual synergies, the firm could report annual profits in this region, valuing the firm at roughly 8 times earnings, given Scientific Games' market valuation. Profits could increase if the firm can refinance its expected sizable $2.8 billion debt position at lower rates.

Shares of Scientific Games have come under pressure as some investors in WMS have been reluctant to sell shares for $26 per share, despite the generous premium. As recent as the start of 2011, shares were trading around $50 per share. Lawyers for WMS investors argue that the deal is the product of an "opportunistic process in which Directors have unreasonably agreed to an unfair price." Investors argue that the purchase price to not adequately reflect the many synergies that results from the merger.

The deal seems excellent for Scientific Games and will be key to a return to profitability. The firm in which Ronald Perelman holds a 38% share has been based on acquisitions including that one of Barcrest, Sceptre Leisure Solutions and GameLogic.

There is definitely value in shares of Scientific Games Corp but the risks are high as well. If the firm can refinance all its debt at 2% lower rates, shares are valued at merely 5 times earnings. On the other hand risks are high given the risks related to this large acquisition, the large increase in leverage and the long term challenges of the industry.

Opportunistic investors could pick up some shares in a bet on a flawless execution of the deal.

Source: Scientific Games Corp - Acquisition Of WMS Industries Offers Potential