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Scientific Games Corp (NASDAQ:SGMS)

Q4 2012 Earnings Call

March 11, 2013 5:00 p.m. ET

Executives

Cindi Buckwalter – IR

A. Lorne Weil - Chairman and CEO

Jeff Lipkin - SVP and CFO

Mike Chambrello - CEO of Asia-Pacific Region

Analysts

Steven Wieczynski - Stifel Nicolaus

Mike Malouf - Craig-Hallum Capital Group

Todd Eilers - Eilers Research

Operator

Good evening, ladies and gentlemen, and welcome to Scientific Games fourth quarter and year end 2012 conference call. At this time all participants are in a listen only mode. A brief question-and-answer session will follow the formal presentation. As a reminder this conference is being recorded. It is now my pleasure to introduce Cindi Buckwalter, Vice President for Scientific Games. Ms. Buckwalter, you may begin.

Cindi Buckwalter

Thank you, operator. Welcome and thank you all for joining us this afternoon. During this call, we will discuss our fourth quarter and year end results followed by a question-and-answer period. Please refer to our press release for further details.

As a reminder, this call is being simultaneously webcast and is accompanied by a slide presentation. They’re both available along with our press release in the investor information section of our website at www.scientificgames.com. A replay of the call and the accompanying slide presentation will be archived in the investor information section of our website.

This conference call will contain statements that constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties that could cause actual results to differ materially. For certain information regarding these risks and uncertainties please refer to our earnings press release and materials relating to the costs posted on our website and our filings with the SEC, including our most recent annual report on Form 10-K and our subsequent reports filed with the SEC.

During this call, we will discuss certain non-GAAP financial measures. A description of each non-GAAP measure and a reconciliation of each non-GAAP financial measure to the most comparable GAAP financial measure can be found in our earnings press release.

Now I’ll turn the call over to Lorne Weil, Chairman and CEO.

A. Lorne Weil

Thanks Cindi. Good morning everyone. And thank you for joining our fourth quarter 2012 earnings call. With me this evening as usually are Jeff Lipkin, our CFO and Mike Chambrello who runs our Asia-Pacific business. Also here is Jack Sarno, our chief legal officer, in case anyone has a question in that direction.

We were pleased with the results of the quarter and the full year. Our year-over-year revenue grew 4% in the quarter and 7% for the year and our attributable EBITDA increased 13% in the quarter and 5% for the year. Notably attributable EBITDA from our wholly-owned operations, that’s to distinguish them from our interests in joint ventures, increased by 17% year-over-year in the fourth quarter.

We benefited from solid lottery retail sales not only in the U.S. but also in Italy where instant ticket sales grew year-over-year for the first time in calendar year 2012. More importantly, we feel very confident about the way the business is developing strategically with much of that confidence stemming from our recent development activity and most importantly, our pending acquisition of WMS. As I think probably most of you on the call know at the end of January, we reached an agreement to acquire WMS Industries -- far and away the most transformative development in our history. This merger would bring together lottery instant tickets and services, gaming machines, lottery and gaming systems, license products for lottery and gaming markets and an array of online products and services.

At the time of the conference call announcing the merger back at the end of January, we explained that its uniqueness lay in the fact that although there is very significant complementarity of functional capability and resources between the two companies the two companies have virtually no competitive overlap. Regarding the latter I am pleased to say that earlier today we were officially informed of the termination of the waiting period under Hart-Scott-Rodino, one of our conditions to closing.

Viewing through a slightly different lens, the merger is special because we believe it leverages the strategic dimensions about the broad scale and scope - scale through the integration of functional resources like engineering, manufacturing and content development, and scope through the application of the core competencies of each partner to generate new revenue streams in the markets of the other.

We understand that integrating the two companies in a way that derives the maximum benefits of scale and scope will be a demanding task. But we’re also confident that in the period between now and close, we will complete the development of a comprehensive plan to successfully do so.

During the fourth quarter our consortium in Greece increase was provisionally awarded a 12-year concession for the exclusive rights to operate and manage the instant ticket lottery in Greece with Scientific Games expected to be the exclusive instant ticket supplier. We think that implementing the best practices we have successfully used with lotteries around the world will result in the successful relaunch of instant tickets which have been absent from Greece for a little more than 10 years.

Let me now turn to a closer look at the fourth quarter. Generally the quarter was a strong close to a very successful year for the U.S. lottery industry. Our customers’ retail sales of instant tickets rose over 5% and sales of draw games grew nearly 11% benefiting from a record Powerball jackpot of over $587 million in the quarter.

For the year our customers’ instant ticket retail sales increased over 9% in 2012 and our lottery systems customers’ sales growth approached 12%. After several quarters of declines instant ticket retail sales in Italy grew nearly 4% in the fourth quarter.

Normally I would turn things over to Mike to discuss China but to allow more time for Q&A, I'll touch on that subject briefly myself. Mike is here and he will be available for any China specific questions.

While instant ticket retail sales in China remained somewhat weak in the fourth quarter, we did see an improvement in year-over-year results compared to Q3. There is clearly strong consumer demand for lottery products in China as retail sales of the overall lottery segment in China grew by 18% in 2012. However we believe that the rollout of a competitive draw-based lottery product over the last year has directly instant tickets. Of the same token, as the rollout of this product reaches maturity or saturation, we are confident that the trajectory of instant tickets will turn more positive.

In the meantime we remain focused on improving sales trend by providing more retail sales, retail points-of-sale and by implementing a revised marketing strategy, which includes increasing our involvement in the game selection process. This plan includes launching the types of games that have been successful in other parts of the world, such as extended play games and families of games that contain common themes that are grouped together at retail to increase consumer awareness.

We've also removed stale inventory from retailer locations and warehouses in all provinces and are replenishing this inventory with new games. Our weekly results are beginning to reflect all these developments. Sales in each of the last two weeks were respectively the highest of 2013 and our share versus the China Welfare Lottery climbed to 52% last week. We continue to believe in the long-term growth opportunity in China and our infrastructure there have proved very beneficial once we begin to pursue opportunities for the WMS business in the Asia-Pacific region.

Moving to our gaming operations, our UK gaming business again experienced an increasing gross win per terminal per day although overall results were affected by the loss of the William Hill contract. Still our UK licensed betting office machine performance was strong with Ladbrokes’ gross win per machine per week and gross win per shop per week increasing by 10% and 11.5% respectively in 2012.

Speaking of Ladbrokes and William Hill, I should mention that William Hill just announced its quarterly results, and we can use these to conclude the following: in 2010 Ladbrokes was number three in the UK running 400 pounds per week per shop behind William Hill. Today in early 2013 Ladbrokes is number-one running 132 pounds per week per shop ahead of William Hill. If we do the math, then based on 2000 shops for each, this is a swing of at least $88 million, most of which net of our fee would go to the bottom line. So this is a tremendous testament to the strength of our system and our technology in the UK.

We have made progress in our interactive business as well. The Maryland Lottery became our eighth Properties Plus customer and we see additional opportunities in the pipeline to provide this program to other customers. The rollout of video gaming continues to progress in Illinois. Our central system is currently monitoring about 4200 machines in over 1000 locations and these numbers are steadily increasing.

To summarize then, we’re pleased with the company’s direction and of course we’re particularly excited about the prospects for the WMS merger. While we continue to invest quite heavily in content, technology and business development in both our lottery and gaming businesses, the traction we’re gaining is translating into increased return on invested capital.

Return on invested capital was approximately 19% for calendar 2012 compared to about 16% in 2010, just two years ago. At the end of 2010, I indicated that our goal was to move return on invested capital into at least the mid-20s if higher. So while we have made nice progress we still have a ways to go.

And now I’ll turn things over to Jeff to discuss our financials.

Jeff Lipkin

Thanks Lorne. Hello everyone and thanks again for joining us this evening. Overall we’re very pleased with our fourth quarter results. Our performance reflected strength in our instant ticket business in the United States and in several international jurisdictions. Our U.S. lottery systems business also grew nicely led by strong domestic and international sales revenue along with growth in U.S. service revenue. This underlying strength was somewhat masked this quarter by lower revenue from China.

Our UK gaming business continued to drive gross win for our customers, however gaming revenue declined primarily due to impact of a loss of contract and closed business. SG&A decreased $1.7 million year-over-year primarily driven by a $3.5 million decrease in compensation related charges, including adjustments to our accrual for the Asia-Pacific incentive program along with the $1.1 million reduction in professional fees. This was partially offset by a $1.4 million increase in accounts receivable reserves, $800,000 of increased severance and $800,000 of increased overhead from acquisitions.

Attributable EBITDA for the quarter grew 13% to $90.6 million from $80.3 million in the prior year. Attributable EBITDA growth was driven in large part by higher results from our lottery business. Attributable EBITDA also benefitted from the aforementioned lower SG&A expenses in Q4 ’12.

Operating loss for the quarter was $6.3 million, principally driven by an increase in depreciation and amortization of $33.8 million in large part due to a $24 million write-off of gaming terminals and software and a $5.8 million of asset impairment charge.

Our earnings from equity investments increased by $4.7 million year-over-year, primarily due to higher results from RCN and LNS partially offset by lower results from Sportech. We realized a $2.3 million increase year over year in other income expenses on our P&L primarily due to foreign-exchange transaction gains in 2012 versus transaction losses in 2011. These factors resulted in a reported loss for the fourth quarter of $24.7 million or $0.29 per share.

With that high level overview I will go through in greater detail the results of the quarter. Printed products revenue increased nearly 4% in the quarter. This was driven largely by a $5.5 million increase in international revenue led by Italy and the UK, also realized a $1.6 million increase in revenue from U.S. customers who compensate us based on a percentage of retail sales, including our cooperative services customers and $1.5 million from the acquisition of Provoloto. This growth was particularly offset -- partially offset by a $2.9 million decrease in our license property business and a $2 million reduction in revenue from U.S. customers who buy tickets on a price per thousand unit basis.

Printed products’ operating income grew 6% to $34.1 million compared to $32.2 million last year, driven in part by a higher and more profitable revenue mix and a $1.4 million decrease in SG&A principally due to reduction in compensation expense. This was partially offset by a $1.7 million increase in depreciation and amortization primarily due to a write-down of software development costs along with the $1.1 million of employee termination restructuring costs related to the closing of our Australian plants.

Lottery systems’ revenue increased 16% year-over-year, reflecting higher equipment and service system sales revenue. Service revenue was essentially flat compared to the prior year. Strength in our U.S. business resulted in a $4.1 million revenue increase, driven in part by the impact of a record $588 million Powerball jackpot in the quarter which was largely offset by a $3 million lower international revenue principally due to the decline in China systems revenue.

Lottery systems’ operating income decreased to $9 million from $11.1 million last year, primarily reflecting $5.8 million in non-cash asset impairment charges partially offset by the benefit of higher revenue year over year. Gaming revenue declined 12% year over year your due in part to the loss of $2 million of revenue from the William Hill contract and $1.9 million revenue from our Australian over-the-counter business. Results also reflected a $1.6 million decline in revenue from outside of the UK, a $1.4 million reduction in sales revenue following the exit from the analog terminal business and a $1 million reduction in revenue due to softness in our pub business.

Revenue from LBO customers in the UK increased by $1.3 million demonstrating gaming’s continued success in driving cash gross rate (ph) for our UK LBO customers. Gaming operating loss was $25.4 million compared to operating income of $2.8 million last year primarily due to a $25 million increase in D&A. This increase reflected a $12.5 million write-down of terminals and software in our pub business and a $10.2 million write-down of LBO terminals primarily related to customers transitioning to newer generation machines.

Moving on to the balance sheet, our debt less cash at quarter end was approximately $1.4 billion, our liquidity stood at $315 million, including $206 million of availability under our revolver and cash of $109 million. Our debt less cash to trailing 12 months attributable EBITDA remains below four times.

During Q4 we purchased 2.7 million shares with a total of 9.2 million shares purchased during 2012. Our free cash flow for the quarter was $17.5 million compared to negative $5.1 million in Q4 last year due to an increasing cash flow from operating activities, including a reduction in working capital needs, partially offset by increased CapEx.

We also received the return on capital payments of $6.5 million from our equity investments during the quarter, which are not included in our free cash flow metric. For the full year, free cash flow was $45.5 million compared to $79.2 million last year. Total CapEx for 2012 was $113 million versus $91.9 million last year. However the $91.9 million amount in 2011 excludes $31.2 million in an equity investment to fund the acquisition of gaming terminals, which was not included in CapEx under GAAP accounting. However taking that into account, cash flow metric in 2012 was pretty consistent to 2011.

To wrap up, the quarter's results reflected the strength of our operations in most parts of the world led by strong performance of our U.S. lottery business and growth in Italy. As we enter 2013 retail sales in Italy started off a bit weak but trends seem to be improving as we are progressing through the quarter. The U.S. lottery industry has also gotten off to a slow start in 2013, we believe due in part to the strong comps we experienced in Q1 ‘12 when retail sales of instant tickets rose over 12% and lottery system sales grew nearly 16%.

Decline in instant ticket retail sales in China are continuing in 2013 but year-to-date we've experienced an increase in our share and are seeing some early indications of our return to growth. From an operational standpoint, we continue to develop our business for the long term and are pleased to report the progress that Lorne mentioned regarding our improvement in our ROIC metric.

As Lorne mentioned, we’re very excited about the WMS acquisition and how it will transform our company. We are making good progress on key milestones for closing. We're extremely focused on completing the transaction that we can begin to leverage the many opportunities we see for the combined companies.

It’s worth noting that we will incur a number of WMS transaction related costs in 2013. Specifically we currently expect to incur regulatory cost, professional fees and other expenses totaling approximately $46 million in the first quarter of 2013 with additional amounts to be incurred in balance of the year, with the large impact hitting our P&L at closing.

With that, I will turn it back to Lorne to wrap things up.

A. Lorne Weil

Thanks Jeff. That’s a good report. Now I don’t have any further prepared comments. So operator, if you care to, can you please open up the line for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Steve Wieczynski with Stifel.

Wieczynski - Stifel Nicolaus

So Lorne, maybe this is about a question for Mike but you talked about China little bit and can you just give us a sense of how you're thinking about China for this year just in terms of where the market can go and your growth opportunities? And also the ASP, I know that’s something you talked about in the past, being able to drive that number up and it really hasn’t moved too much over the last couple of quarters and just how you’re thinking about the ASP going forward?

A. Lorne Weil

Mike’s here, I will pass to Mike to answer that.

Mike Chambrello

So ASP is sort of one piece of a puzzle but really what’s happened over the last I don’t know, four, five, six quarters is that very similar to what happens in other new jurisdictions that sort hit the middle third – beginning of the middle third of their lifecycle which have is, a lot of people that have had greater exposure, customers in particularly, obviously CSL, CSLP begin to have greater opinions on what product should look and really what we experienced is the proposed games for on a quarter by quarter basis would go through the review and approval process. We experienced a lot of little tweaks, maybe a little tweak to a color, or call-out or price structure or other things and really what we recognized at the end of last year was all of those little tweaks were really changing not only the product, the product positioning, the process in which it was launched, the order in which it was launched. So I am really happy to say that we jumped on that and got great customer support on that and Lorne mentioned the last few weeks have shown a pretty significant directional change anyway and those games were that are driving that change were the first games that went through our revised process and all of the games scheduled for Q2, Q3 are going to what we would refer to internally as (inaudible) games certified, which frankly I wouldn’t have said that over the last six or seven quarters.

So as we look out at Q2, Q3, Q4 I think the game offering versus our competitor in this case CWL will be better. ASP is a part of that but it's not the driver in this case and certainly retail expansion which the lottery has done some very good things that aren't that I can’t really comment on at this point. So I think the revised game, the certified game which will help us to start to increase the ASP again along with some real improvements in the infrastructure over the course of the next six or eight months, combination of all of that is I think there is reason to think that we can get back on a growth pattern.

Wieczynski - Stifel Nicolaus

And then for Lorne, I guess there was no mention anywhere of Northstar, so can we just get an update in terms of how that's going and then potential opportunities for Northstar going forward as well?

A. Lorne Weil

Northstar in Illinois continues to go very nicely, we’re continuing on the growth path that we have been on since we launched. We’re still waiting to hear what the final outcome is of the performance measure for 2012, but regardless of how that works out, there is no disputing that the absolute performance in 2012 was excellent and is continuing very well in 2013. The other two North American opportunities on the potential horizon for Northstar would be New Jersey where I think it's fairly well known that the bid of Northstar was the only valid bid that was submitted in response to the RFP and at this point the matter is in the hands of the New Jersey state government to decide whether and what and how they want to proceed from here. And as you may know there is an RFP-Q so that’s a pre-qualification RFP circulating on the matter of lottery private management in the province of Ontario, Canada. I think to the best of my knowledge that’s all that’s on the dock right now, Jeff, unless you are aware of something else.

Jeff Lipkin

There are some international ones that are starting to get some traction but they are a little bit way off.

A. Lorne Weil

But in terms of potential for Northstar, those would be the most active things right now.

Wieczynski - Stifel Nicolaus

And then last question, I guess it’s been about a month and a half since you announced the WMS deal. And can you give us an update in terms of, as you’ve got another 90-day to kind of work through everything, I am not sure you’ll be able to answer this but do you still feel pretty comfortable that with all the numbers that you put out there and basically what I am trying to get at is do you feel still pretty comfortable with the synergy estimates that you put out there?

A. Lorne Weil

Yes, I think there is a few things that you have to bear in mind as Jeff and I both mentioned, we’ve only just today been cleared in Hart-Scott-Rodino. So there are certain conversations that we would want to be able to have in order for me to be a million percent definitive in responding to that question, that we haven’t, until today we weren’t able to have, so I can certainly tell you that based on the best information that we’ve been able to legally look at since we had our conference call in January 31, we don't have any reason to think that the synergy estimates and the general outlook that we presented five or six weeks ago are not valid today.

Jeff Lipkin

Steve, the only thing I would add is that if anything in the discussions that we were able to have I think are getting more opportunities for revenue synergies, we really didn’t include any revenue synergies in what we put out before. So one way to get more comfortable of cost synergies is to realize that there are meaningful revenue synergies. So I think the overall quantum of the number at least from my perspective continues to feel pretty good.

Operator

Your next question comes from the line of Mike Malouf with Craig-Hallum Capital Group.

Mike Malouf - Craig-Hallum Capital Group

Yeah, I think this is the first time in a while at least that you had shouted out into kind of a shadow guidance with regards to the first half starting off a little bit more slowly. I'm wondering if you could just give a little bit more color on that and then as sort of a tangential question, as you look back on Powerball's $2 dollar price, so the raise from $1 to $2, how has that in your mind been a success or does that ever need to be tweaked or is that sort of set in stone that is ready to -- are we going to see the I think synergies that people talked about?

Jeff Lipkin

So I'll take the first question. In terms of being guidance, I don't know if it's necessarily guidance, I think what we recognized this quarter in particular is that it’s March 11. And while we're doing the year-end results, we're quite a way into Q1. And these retail sales particularly China and Italy and the U.S. are sort of publicly available. So we felt it was important to not only present what we saw at the end of Q4 but to sort of bring down to what we're seeing today and discussing the recent trends that we’re seeing provide is down (ph) of those discussions on the quarter and year-to-date as we could. So I wouldn't at all call it guidance because as you know, I think we have a pretty strong view on guidance as does our board, but rather just sort of helpful color that we think was useful for investors and analysts to understand what's going on.

In terms of the $2 Powerball, in terms of tweaks I think they are continuing to look at alternatives or additional game features, both with both national games, both national draw games and I think you'll continue to hopefully see innovation along that line with higher price points, additional price points, things of that nature.

A. Lorne Weil

Mike, it's Lorne. I'm not exactly sure where it stands but I know I've been hearing a lot of talk about the possibility of California joining Powerball. And if they were to do, it would be such a significant increase in the total revenue of Powerball because although there are a lot of states in Powerball, California dwarfs most of them in terms of size. So that would require more than a tweak I'm guessing, that would require a significant revision of the metrics in order to make the whole thing work. So I imagine that they would then take that opportunity to address some of the issues that Jeff was talking about.

Mike Malouf - Craig-Hallum Capital Group

Is that still supposed to start in April?

A. Lorne Weil

I beg your pardon?

Mike Malouf - Craig-Hallum Capital Group

Is that still supposed to start in April?

A. Lorne Weil

I'm not sure but I believe so. Yes.

Mike Malouf - Craig-Hallum Capital Group

And then what would be the timing as far as the Greek lottery? Do you have any update on that how that would roll out for you?

A. Lorne Weil

Now we're continuing to watch it. There seems to be developments day by day. Our best guess is that we’re close in that we’re maybe -- I think early Q2 is probably my best guess of when we might get results. I think a start-up would be later in the year in terms of when a signing might be officially. Maybe end of this quarter, beginning of next quarter timeframe with operational start-up later part of the year.

Mike Malouf - Craig-Hallum Capital Group

And then one final question with regard to capacity. Where are you with regards to ticket capacity for your worldwide sales, are you -- do you still have a lot of capacity to go, or will you need to add capacity?

A. Lorne Weil

We're actually very, very tight on capacity. The market has continued to grow and it's sort of amazing what even mid or high single-digit growth does when it compounds over a period of a few years. So we're very tight in capacity. We have a plan that has been implemented that will very significantly increase the capacity of our plant in Georgia. We should be getting this capacity into the plant in Georgia sometime in the latter half of 2013. And we should begin shipping from that capacity early in 2014.

When we bring that press in, we'll be decommissioning as we say in this business or taking the oldest press that we have into plant out of service. At this point, just because of the way the business has changed over the last several years we probably don't operate that press at more than 50% capacity because it's just not usable for much more than that. So and the capacity of the new press is with the old press running under the best of circumstances a multiple of the old press's capacity. So the net impact will be – will not only have a considerably more capacity, it will be much higher quality, much more efficient and much lower cost and we'll see that up and running the first part of next year.

Operator

(Operator Instructions) Your next question comes from the line of Todd Eilers with Eilers Research.

Todd Eilers - Eilers Research

Wanted to ask a few questions on the lottery systems side. Obviously strong growth in that segment with the record Powerball, but was kind of curious as to why maybe we didn't see a little bit better flow-through on the gross margin side. Would that have anything to do with the weakness in China systems and/or potentially I guess start-up costs for the Illinois central system, just a little bit more color there would be helpful.

A. Lorne Weil

Yeah, you hit it. Pretty much the increase in the domestic retail sales from Powerball and Mega Millions were offset almost entirely by shortfalls from China given the high-margin that both of those service revenues have.

Todd Eilers - Eilers Research

And so would you view kind of that the gross margin that you had in the quarter then is kind of a reasonable number going forward then as well?

A. Lorne Weil

It really comes down to mix and I mean obviously when we have quarters like we did last quarter with the high jackpot, then we would expect it to tick up and if it wasn’t for the China shortfall you would've seen that more pronounced in our results.

Todd Eilers - Eilers Research

And then on the sales side for the lottery systems, pretty strong quarter and forgive me if you mentioned what drove that, just kind of curious what the driver was on the sales side.

A. Lorne Weil

Yeah we had some replacement of terminals internationally, particularly Germany was strong for us as we go through replacement cycles there for point of sales equipment and then it was growth of our BOP (ph) segment.

Todd Eilers - Eilers Research

And then just last question on the global draw footprint, looks like your number of games at the end of the quarter jumped up a fair amount, it looks like about over 1000 games sequentially. Can you maybe talk a little bit about what drove that and should we have any impact from that going forward?

A. Lorne Weil

I think that was a little bit of increased density at some of our UK LBO customers, and then I think there were some terminal deployments internationally.

Operator

There are no further questions in the queue at this time. I’d now like to turn the call over to Mr. Lorne Weil for closing remarks. You may proceed sir.

A. Lorne Weil

Thank you, operator and thanks everyone for taking the time at late in the day to dial-in. I think I would echo Jeff’s remarks that we are very pleased with the quarter. We’re pretty excited about how 2013 is beginning to shape up. We’re obviously extremely excited about the prospects for the WMS acquisition and how that will integrate with Scientific Games. And we look forward to seeing you, actually not a quarter, fairly soon when we report the first quarter. So thanks and good evening.

Operator

Thank you for your participation on today’s call. This concludes the presentation. You may now disconnect. Have a great day.

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