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Executives

Joseph R. Wright - Chief Executive Officer

Michael R. Chambrello - President and Chief Operating Officer

Jeff Lipkin - Chief Financial Officer, Vice President

A. Lorne Weil - Chairman of the Board

Analysts

Bob Evans - Craig-Hallum Capital

Carlo Santarelli - JPMorgan

Lawrence A. Klatzkin - Chaplain Credit Partners

Scientific Games Corporation (SGMS) Q3 2009 Earnings Call October 26, 2009 12:00 PM ET

Operator

Hello, everyone and thank you for joining us this afternoon. With us today are Lorne Weil, Chairman; Joe Wright, Chief Executive Officer; Mike Chambrello, Chief Operating Officer; Jeff Lipkin, Chief Financial Officer; Ira Raphaelson, General Counsel.

During this call, we will discuss Scientific third quarter 2009 financial results followed by a question-and-answer period. A replay of the call will be available at the company's website, www.scientificgames.com, for 30 days.

As a reminder, this call is being broadcast live. Please refer to today’s press release for full details.

Before turning the call over to management, Scientific Games would like to remind you that this conference call will contain statements that constitute forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. This information involves risks and uncertainties that could cause actual results to differ materially from the forward-looking statement. For certain information regarding these risks and uncertainties, references made to the Scientific Games Annual Report on Form 10-K for the fiscal year end of December 31 of 2008.

Now, let's begin. Mr. Wright.

Joseph R. Wright

Okay, thanks so much. Good afternoon and welcome to our third quarter earnings call. I am Joe Wright and with me over here as the Operator mentioned are Lorne, Jeff, and Ira.

Mike Chambrello, our President and Chief Operating Officer, is actually calling in from Chile where he is at the World Lottery Conference.

Now our agenda for today’s call is as follows -- I am going to first share with you some of my thoughts on the third quarter and the year-to-date. Mike is then going to review some of the important operating results. Jeff will take you through our financials and finally Lorne will provide some closing comments.

Now in the third quarter just ended, much like the prior two quarters of this year, our revenues continue to be primarily impacted by factors that are not driven by the fundamentals in our underlying business, such as foreign exchange, contract repricings, and the movement of our China printing operations to our joint venture line. But right now, as we’ve stated before, we are managing this business for free cash flow and you can see the results that we published this afternoon that we continued to deliver on that metric.

First let me give you a top level review of our markets and our business, which are actually holding up very well. On the quarter to quarter basis, we are increasing revenues and EBITDA and while our retail sales from our lottery business in the United States, particularly the instant ticket business, is flat to slightly down, those lotteries where the marketing and promoting their business are growing, some of them even in the 10% range over last year.

The U.S. online business continues to benefit from better jackpot [rules] from Powerball and Mega Millions and as a result, 10 of our 13 states are actually up over last year. Importantly, there are some exciting developments that are occurring in this online business and Mike is going to address that for you later.

On the international front, instant ticket sales also remained strong. For example, Italy, while it is large right now, is almost up 2% over last year. The U.K. is almost 10% over last year, and China would be 50% over last year but last year was a partial year, so on an apples-to-apples basis it is probably 30%, 35% over.

Our global draw business continues to grow with the installed base of terminals and the win per day both showing increases. So when you put that all together, our core lottery and server based gaming businesses continue to outperform the broader consumer sector.

Now, given our reputation and success in the U.S. and abroad, it should be no surprise to anybody that we continue to be awarded new contracts. This quarter alone we signed new contracts with Vermont, Arkansas, Delaware, [Bodwortenburg], Germany, and Indiana. And we signed an agreement to provide terminals to the Israeli Sports Betting Board.

I would also like to talk a moment about the extraordinary progress this company has made since initiating the profitability improvement program late last year. Through most of this year, our company has faced not only the previously mentioned factors but also possibly the toughest economic environment you and I are going to see. We responded quickly to both of those items and as a result in each quarter, our gross margin continued to improve over the prior year. And our free cash flow has increased by over $100 million.

We also successfully exited our contract in Mexico, which we said we were going to do, and had negatively impacted our results last year by almost $10 million, and we are actually able to realize some value for our assets.

A further achievement of that profitability improvement program is that cost management, disciplined capital expenditures, and a return on investment focus are now a deeper part of our culture.

Jeff will describe the results of these efforts in more detail but I believe these are significant achievements and our management and employees should be proud of what they have accomplished in a tough year.

Okay, those are my summary comments on how the quarter has gone. Now I’m going to hand it over to Mike to describe some of the key operating results and achievements in more detail. Mike, you’re on.

Michael R. Chambrello

All right, Joe, thank you and greetings from Santiago. I may take a little bit longer than normal as I hit not only the key operating highlights of the quarter but also toward the end of my comments I’ll provide what I hope will be a fairly good roadmap to all of you on what Scientific Games' strategy is not only heading out of this year but more importantly as we head into 2010.

Let me start with, of course, Italy, which remains a primary topic of interest. While most of you are aware of the status of the [Gratavinci] tender, let me begin by just outlining the current situation so that we are all literally on the same page. The new contract is scheduled to begin in June of 2010 and it runs for a term of 9 years with a quality review after five years and an extension option of an additional 9 years. This quality review for five years was really -- is something that we embraced. It was probably put in as a measure of quality and capabilities of lesser known entities. As it turns out, I think everyone is aware that there was only one bidder. It was our CLN consortium and we are proud to be part of that and look very much forward to 9 straight years and hopefully 9 more following.

Pricing, as you know, is fixed. It’s 11.9% of retail sales versus an average of about 2.1% in quarter two of 2009 under both tenders, the old and the new. Our retailers will continue to receive an 8% fee and we will continue to do so. And this is an interesting opportunity for us and we look forward to certainly seeing this tender through its conclusion.

So what’s the timeline and next steps? Bids were submitted on October 12th. As we mentioned, CLN was the only bidder. Not unexpectedly, [Cecil] filed suit in what is the Rome Administrative Court to obtain a suspension and annulment of the RFP. The request was denied a couple of days later on October 14th and though it will be reviewed on 10/28, we have reason to believe that the denial will be overturned and its our expectation that final award will be made on or about 11/15.

Let’s move to the current for a minute and not to be lost in all the tender activity is a continued strength of retail sales in Q3 which as Joe mentioned actually increased 2% year over year. This is really very encouraging, given the historical volumes, the difficult economic environment, and generally weaker sales expectations during the summer months, particularly in Europe and in Italy.

Very early in Q4, the first EUR20 game was introduced, a holiday themed game which people laugh at me when I say this but it’s actually quite beautiful. It’s almost like a work of art. Although early in the sales cycle, initial results are very positive and in the second full week of sales, the EUR20 actually resulted in a 25% share of all scratch tickets sold in Italy.

So while we don’t have complete closure on all issues in Italy, we are very encouraged by the current direction, the increased clarity of the process, and of course and most importantly, the continued strength of retail sales.

Next big issue sort of on the list every time around is our progress in China, and I would like to say we continue to make excellent progress in expanding retail sales in this market. Sales were up in Q3 and they were actually up over the same period in 2008, which as you will recall included the Olympic themed games and many people thought would be the highest single period we had under the term of this contract.

Continuing with that trend, month to date sales in October were actually up over 35% over the same period last year, so sales clearly are strong. We had the introduction of our second RMB20 game, which is called Reach The Top. It’s selling quite well and combined with the remaining tickets of our initial RMB20 game, which by the way is about 90% sold out, together the RMB20 price point is about 34% total sales. Clearly there’s sustained strength in the higher price points and this strategy is supported by the continued success in our average selling price in 2009 from about RMB4.6 to about RMB7.4 today.

So as we look to 2010, we anticipate continued success and expansion at the RMB20 level, as well as the likely introduction of at least one and maybe multiple RMB50 games. However, in order to ensure the increased growth, we need to focus on three prime drivers of sales -- the first is the continued expansion of retailer network, which is currently at a base of almost 160,000 and while it’s up 21% from the first [inaudible] this year, still has dramatic room for growth.

The second is one that is not often recognized or focused on and that is really simply retailer cash flow. Today retailers in China operate literally on a cash and carry basis, often resulting in multiple ticket deliveries in a given day, frequently leaving retailers with out of stock situations for the most desirable games and price points. It’s something that clearly we will need to address over the coming year.

Next of the big three is the setting of provincial sales targets -- when the CSL set its annual sales targets for 2009, they simply didn’t envision the year-over-year growth opportunity. In some provinces, the annual sales targets have already been achieved. As an example, one province which is a top five seller, met its full year sale target in mid-September and sales dropped 75% the following week despite the continued product demand in that province. While this is an extreme case, it’s indicative of how early in the instant ticket life cycle we are in China, while as the near-term limitless opportunity for sustained growth.

We are executing a provincial incentive plan in Q4 to motivate all provinces to continue to drive retail sales through the end of the year and beyond their current targets.

In order to be more efficient and effective, we addressed these drivers. We’ve entered into a formal partnership in the form of a marketing agreement with the CSL. Scientific Games has the leadership role in this partnership and as a result had submitted plans, some of them are in the execution stage, to address each of the three drivers I’ve mentioned above on a province by province basis.

Once executed, we expect these actions to further accelerate sales into year-end and into next year. Just to summarize, we are quite pleased and satisfied with the direction of this market and the outstanding relationship that we have with the China Sports Lottery.

Let me just hit on some other highlights before we talk about the strategy. Joe mentioned global draw -- our installed base has grown to over 17,000 machines and play remains relatively strong in a very, very soft environment, economic environment. The most significant event for global draw in Q3 was the authorization to install up to 1,500 machines, operated by [Camarerro] in the [OTB] and track locations and in about 700 of these licensed OTB parlors. To date, we’ve installed over 500 machines. We expect that to grow to approximately 1,000, maybe more, by year-end and over 1,500 by the end of the first half of next year. It’s conceivable that we could exceed the 1,500 number and accelerate that number early in the year.

We are satisfied with the cash box performance to date in the [Camarerro] venues and we are implementing a plan to drive between $35 and [$50] per day per cash box, so we look forward to really significant growth in Puerto Rico and as global draw rolls out this and other major programs that we have on the drawing board.

Moving to systems, as some of you may be aware, the U.S. lotteries recently agreed to begin cross-selling Powerball and Mega Millions. What this means is that players in all states will have the opportunity to play a big jackpot game four days a week. While this is a significant achievement, it’s really just the first step in a strategically defined plan to enhance the online product and represents the first collaboration at the national level for the online product. As I mentioned, the plan will include a merging of Powerball and Mega Million states, allowing states to sell both games, exposing each game to a larger population and increased jackpots in the short-term. States have targeted cross-selling of Powerball and Mega Millions early in 2010.

Development and implementation of a new national game will be rolled out toward the end of 2010 and price point differentiation, finally something we’ve been talking about for four or five years now, between Powerball, Mega Millions, and the national game will occur, likely in the order of $1, $2, and $5 price points, a very significant breakthrough.

The rollout of this product enhancement plan, if you will, marks the first concerted effort to adjust the online portfolio, as I said, in five to 10 years. While it’s too early to quantify the impact on retail sales for 2010, we anticipate meaningful sales growth with enhanced player participation and interest beginning early next year.

Also worth mentioning in the systems group is the recent trend I pricing for new online contracts. I am pleased to announce, as Joe mentioned, that we are the successful bidder and I’ve actually executed a contract in Indiana. More importantly, however, we received the highest technical score of all three bidders and we were not the low cost provider. Having bid at a rate that will allow us to meet or exceed our internal hurdle rate and a sign that the lotteries are returning to evaluating their investment by choosing solutions that will increase their revenue and return to their beneficiaries, not simply finally choosing simply the lowest cost bidder. We’ve had other indications of similar price increase and we are optimistic that the strategy we employed a couple of years ago is taking root.

Moving quickly to printed products, the big event in printed products in Q3 was the start-up of the Arkansas lottery. It was done in a record 42 days from contract signing, which to me is incredible and I congratulate the team on that. This marked the 34th start-up that SG has led and by all measures is one of the most successful.

As Joe mentioned, overall retail sales for instant tickets remained slightly down or relatively flat for the quarter but we are starting to see signs of improvement in recent weeks in states that have been struggling to stabilize and increase sales. The next 30 days will be very important for the balance of the year as we begin to get an indication if we are going to see the historical bump in retail sales and if so, to what degree. We are optimistic but let’s see where the sale drive us.

We also see an improving pipeline for opportunity, not just in printed products but across the board in areas like Greece, expansion across product lines in Canada, including cost efficiencies associated with the launch of our new press in Montreal; a private management opportunity in Illinois, printed products expansion in the Australasia region, including recent wins in Singapore and the Philippines, so we are starting to see good improvement and an opening in our pipeline and Jeff will talk a little bit about the margin improvement shortly.

So having given that as the summary, let me move on just and finally and for a change just talk a little bit about strategy. Clearly 2009 has been a transition year for Scientific Games. We’ve appropriately focused on cost reduction and profitability improvement and this was needed in this very, very severe economic downturn. However, now it’s simply time to grow.

We at SG finalized our 2010 budget, business plan, and three-year strategic plan. I want to assure you that while we will maintain a disciplined approach to SG&A, operating and capital expenditures, our focus heading into 2010 is on profitable and sustainable growth. It’s premature to provide you the detail of our growth strategy at this time. However, as I mentioned at the start, I’d like to spend just a few minutes and walk you through a high level strategic roadmap, if you will, and we will fill in the blanks in the coming weeks and months.

Let me start by sharing with you just some thoughts on the gaming market today which will drive or continue to drive our strategy for the future. These are wide area proliferation, government involvement, and diversification driven by specialization and facilitated of course by network technology.

Today, we supply technology, content, and services to 34 U.S. states and over 50 countries. Whether government or private government licensed customers, our customers share a number of goals and challenges, including pressure on consumer spending, the need to control their budgets, and the constant pressure to offer the new, the next big thing in the form of gaming entertainment.

There’s a strong desire to expand gaming operations in a way that both increases revenue, ensures responsible gaming and we are fully supportive of that. By and large, they will look to extend their gaming activities through existing regulatory structures. These customers are looking to their preferred suppliers to develop products that can meet these significant requirements.

Scientific Games has built on these customer relationships in the past by continuing to broaden our offering of goods and services and technologies. Our evolving strategy is simply a continuation of this successful theme -- deliver the next generation of products and services in a manner that is exciting for consumers, cost efficient for our customers, and profitable for our shareholders.

So let’s start with wide area. As we anticipated when we acquired Global Draw in 2006 to build upon our core VLT experience, we believe the most interesting growth opportunity in gaming will be in wide area environments. We will see the conventional casino market, characterized by hundreds or thousands of machines in a single venue, as the focus of profitable for Scientific Games. Rather, the growth is in wide area distributed gaming environments.

In the U.S., for example, riverboat and Native American class 2 casinos, along with the [casinos], have been major sources of gaming growth. Moving forward, however, we believe the growth is in distributed environments and that growth will be created by expanding distribution to local venues. We’ve already seen tremendous growth in Europe, North America, and other parts of the world in gaming venues such as pubs, bars, restaurants, truck stops, a betting shop, small halls, arcades, et cetera, and other easily accessible areas. Internet gaming is maybe the extreme example of the shift to wide area. While still in its early stages due to the evolving regulatory market but clearly it’s coming and we will be prepared.

Distributed wide area markets require a different cost structure than the historical commercial casino base systems and a very different set of core competencies in areas such as system design, field operations, network management and development, content management and field operations. These are competencies that we’ve had in place for 20 years and are highlighted by our expanding Global Draw technology and commercial model.

Next, government sponsored and regulated environments -- governments are active not only as regulators of gaming but increasingly as sponsors, a good thing. Governments are playing a far more active role in shaping and reshaping their gaming environments, affecting not only their gaming activities but the activities of suppliers in their jurisdictions. Governments are seeing their gaming enterprises as potent and valuable assets to be built upon, not ignored. As illustrated by the recent Portugal decision, they are looking beyond the traditional scope of their activities and in some cases even beyond their borders. They are driving affirmative change through legislation and regulation. There is a level of trust and confidence in working with suppliers that are already aligned with and licensed to meet these government goals, an accomplishment that we at Scientific Games had prided ourselves on for years.

Finally, what we will refer to as diversification and specialization, it’s becoming clear that players are no longer loyal to a single or specific venue. Players want to choose among different venues and delivery vehicles. They want to be able to use a common electronic wallet, whether they play in shops, at home, on the Internet, or on their iPhones. They want to be rewarded for their play across all delivery vehicles.

Diversification of course requires a technology platform that is seamless, integrated, and adaptable to multiple delivery channels. Scientific Games anticipated this trend. This is precisely the direction, the strategic direction that we are pursuing. We’ll be taking a cutting edge B2B Internet technology and linking it with our lottery systems and extending it to new distribution channels. We are not approaching this challenge by stitching together numerous systems like one for poker or one for bingo, one for sports, one for lottery and so on, but are developing extensions from one basic platform. We are weaving together best-in-class next generation capabilities -- not necessarily the first to market, as you will see in this year -- we are bringing together second-to-none capabilities. Thus, while we diversify, the delivery options consistent with the needs of our regulated customers, we will be doing so based on our specialized core expertise, delivering industry leading technology and content driven solutions for the future.

The strategies, which have really been such a significant part of the success we’ve enjoyed in our core lottery business, will drive the next chapter of SG’s profitable growth story.

To summarize and finally conclude, our strategic actions in these markets we choose to serve have really just a few common themes -- growing our customers’ business and expanding their market, providing value-added products and services, continue with laser like focus on quality, security, and compliance and as I think as our recent track record indicates, increased and continued focus on ROI, free cash flow, and long-term balance sheet focus. Internally, we are very, very excited about the direction of our strategy and the strength of our core business and I look forward to sharing with you the how as we proceed through the next coming months or so.

So for now, stay tuned and get ready for profitable and continued growth.

Sorry for the length but it’s a lot to cover and what I’d like to do now is hand it off to Jeff. Jeff.

Jeff Lipkin

Thanks, Mike. In my part of the call, I will discuss our consolidated third quarter results, as well as the financial highlights for each of our segments, and finish up with an update on our capitalization and liquidity position.

In the third quarter of 2009, our revenues were $239 million, which represents a year-over-year decline of $53 million. Approximately $36 million, or two-thirds of the decline in revenue can be attributed to three factors that Joe mentioned earlier in his prepared remarks, namely one, our CSG joint venture taking over instant ticket production for China and our accounting for the activity on the equity income line going forward; two, the impact of specific lottery contract repricings that occurred last year, namely Pennsylvania and Florida; and three, the impact of FX on our reported results.

The first two items should cease to have a negative impact on our year-over-year comparisons beginning in the first quarter of 2010 as the new terms of our contract in Florida will anniversary in October and the new terms in the Pennsylvania contract and the China printing contract accounting change will anniversary on January 1.

With respect to FX, we obviously cannot fully control the impact of FX on our reported results but are encouraged by the recent strengthening of the Euro and the Pound, given our exposure to those two currencies.

Again, we think it’s important that we highlight these factors and have on each of our calls for you since we believe they mask the current underlying trends in our business. We think these underlying trends are positive, particularly considering the current economic environment, and the impact on sales of other forms of consumer products.

This is underscored by the fact that our revenue and adjusted EBITDA grew sequentially this quarter and we had revenue growth in each of our three segments. Furthermore, we achieve margin gains and a significant improvement in our free cash flow quarter over quarter.

Gross profit was $100 million, or a decline of $16 million from Q308; however, gross profit margin improved to 42% from 40% in the third quarter of 2008. The year over year improvement in gross profit margins was primarily the result of commencing production locally for our customer in China and over $4 million of profitability improvement program savings, or what we internally call PIP.

In addition, there was a one-time benefit in our results this quarter from our earlier-than-anticipated shutdown of Mexico and a one-time benefit from an insurance settlement realized during the quarter.

Adjusted EBITDA, which includes our income from joint ventures but excludes the impact of stock-based compensation and is normalized for non-recurring items, was $82 million for the quarter as compared to $97 million in the same period last year. The decline of $15 million was due to the impact of previously mentioned items offset by $3 million of PIP driven SG&A savings. Importantly, adjusted EBITDA margins improved versus Q308.

Depreciation was lower by approximately $4 million, primarily due to the impairment of the Mexico and Oklahoma contracts in Q408 and lower depreciation on our new Pennsylvania online contract. Interest expense was $23 million, which included $1.5 million of non-cash synthetic interest expense related to our convertible debentures and deferred financing fees.

Net income was $15 million, or $0.16 per share, compared to $22 million or $0.23 per share in Q3 2008.

Adjusting for non-recurring items in both quarters and stock-based compensation, non-GAAP adjusted EPS was $0.24 per share, which is a reduction from non-GAAP adjusted EPS of $0.32 in Q3 2008. We are very proud of our PIP related savings and as we have achieved approximately $18 million year-to-date in savings towards our target of $15 million to $20 million in 2009.

Also, we are making good progress on our procurement optimization initiative, which we believe will deliver much of the $10 million to $20 million of run-rate savings expected in 2010.

Now I’d like to spend a few minutes reviewing our financial highlights for the quarter in each of our segments.

Printed products group service related revenue declined approximately $20 million year over year. However, $21 million, or 62% of this decline, was related to FX, the switching of selling instant tickets in China through our joint venture, and our contract re-pricing in Florida. There was also a decline in our licensed properties division as a result of tough comparison related success we experienced with deal or no deal licensed game in 2008 and the impact of losing spots for licensed games due to conflicts with the NFL branded instant ticket initiative.

We are encouraged that our sales this quarter to Camelot, our customer in the U.K., have improved year over year and we are now beginning to see the benefit we expected from their conversion to a revenue participation contract with that customer. As Joe mentioned, retail sales of instant tickets in the U.K. are up approximately 10% year-to-date.

Printed products gross margin improved by 200 basis points year over year due to producing instant tickets for China locally via our joint venture and savings associated with PIP, partially offset by the impact of revised contract terms and a reduction in phone card sales.

The $7 million in adjusted EBITDA -- the $7 million decline in adjusted EBITDA to $38 million was partially offset by $1 million of PIP savings.

In the lottery systems group, revenue declined by $12 million, of which $9 million, or 75% of the decline was related to our contract in Pennsylvania and FX. Lottery systems gross margins expanded by 400 basis points as a result of PIP, benefits from an insurance settlement, and a reversal of an accrual related to the Mexico shut-down, and better margins on our hardware sales.

Adjusted EBITDA declined by $6 million year over year, which includes the benefit of $2 million of SG&A savings related to PIP.

Our diversified gaming group revenues declined by $7 million, of which $4 million was related to FX and $3 million was due to a one-time content sale in Q308. Global Draw service revenue continued to perform very nicely and experienced attractive constant currency growth.

Diversified gaming’s gross margins and adjusted EBITDA declined by 200 basis points and $4 million [commerce respectively]. The year-over-year decline in margins and adjusted EBITDA was primarily related to a non-recurring content sale by Global Draw in Q308.

Moving on to our cash flows for the quarter, cash flows from operations were $45 million in the third quarter of 2009 as compared to $33 million in the same period in 2008. The increase was largely due to improvements in working capital management.

Our total capital expenditures were $24 million for the quarter, which compares to $49 million in the same quarter last year. Year-to-date, we’ve spent $80 million on capital expenditures versus $164 million in the first nine months of 2008.

We continue to be very diligent on reviewing requests for capital expenditures and remain focused on ensuring that we exceed our required cash on cash return threshold.

As we have said before, we have enhanced our focus this year on free cash flow generation and we are pleased with our results to date. Internally, we define free cash flow as cash flow from operations less total capital expenditures. In the third quarter, we generated $22 million of free cash flow, which compares to an outflow of $16 million in Q3 2008. Year-to-date, we have generated approximately $96 million of free cash flow compared to an outflow of $18 million in the first nine months of 2008.

I want to point out that in the free cash flow number that we reported this quarter, that there was a $1 million outflow related to a [SERF] payment that negatively impacted cash flow from operations. However, this was offset by a $1 million inflow in cash flow from investing activities in a related transaction. These two amounts net out in the cash flow statement but for definitional purposes, the inflow is excluded from our free cash flow figure as presented.

This definitional anomaly will also be present in subsequent quarters where there are [SERF] distributions made and we wanted to point it out to you.

Moving on to the balance sheet, during the quarter we repurchased approximately $43 million of face value of convertible debentures under our previously announced repurchase program, bringing the year-to-date total repurchased to $175 million. Currently the outstanding obligation on the convertible debentures stands at approximately $99 million. Our net debt at September 30 was approximately $1.1 billion. At the end of the quarter, we had approximately $200 million of availability under our revolver which reflects $50 million of drawn letters of credit outstanding and no amounts outstanding under our revolver. And when we combined it with the $213 million of cash on hand at the end of the quarter, that gives us about $415 million of liquidity.

That concludes my prepared remarks. I’ll turn it back over to Joe.

Joseph R. Wright

Thanks, Jeff. You know, it’s one thing to achieve good financial results when your revenues are going up. It’s outstanding to achieve them when you have tough economic times and that’s exactly what we have done.

Finally, as you may have read an announcement that we made about an hour ago, we’ve got a few organizational changes to talk to you about. As you know, I came into Scientific Games with a specific goal -- to improve the management process resulting in a reduction in capital and operating expenses, increased operating margins, and expansion of free cash flow and an emphasis on return on investment.

Now, I’ve got to tell you -- I’m surprised that this company accomplished those goals much quicker than I expected and as I stated earlier, Scientific Games is now strongly positioned for profitable growth. So I now plan to retire at the end of this year and will be succeeded by Mike Chambrello, who you heard from just a few moments ago, who is in my opinion one of the most respected and qualified executives in our industry. He’s terrific.

We also expect to form an Office of the Chairman, which will consist of Lorne Weil, Mike, Jeff, and David Kennedy, who will serve as Vice Chairman. David is a former CFO and CEO of Revlon and we are lucky to have a talented, experienced executive like him join our board.

I am going to return to my former position as a member of the board where I will support the management team in continuing the progress we’ve made on management improvements in this company. This new executive team I’ve got to tell you is strong, just like our company.

Having said that, I am now going to hand it over to Lorne for final comments. Lorne.

A. Lorne Weil

Thank you, Joe. Hello, everyone and thank you, Joe, Mike, and Jeff for terrific presentations this afternoon and for the opportunity of saying a few words myself.

I think I mentioned when I last participated in one of these calls just about exactly a year ago that I had at that point done between 65 and 70 consecutive quarterly conference calls and that I was definitely looking forward to a good long break, as no doubt were more than a few other participants on that particular call. But this is a very unusual moment in the evolution of the company, so at the risk of creating some further disappointment, I’d like to temporarily interrupt my break and offer a few comments.

When we announced back in I think May 2008, about 18 months ago, that Joe was stepping into the CEO slot, I don’t think we understood the voyage through a perfect storm that we had handed off to Joe. We had a pretty clear sense that the economy had been in a recession since November 2007 but based upon economic history, we can reasonably had expected that it was close to running its course. At the same time, the re-pricing of a group of very profitable legacy contracts was in the process of impacting our profitability to the tune of tens upon tens of millions of dollars, and to complete the perfect trifecta, the dollar moved strongly in the wrong direction at precisely the moment that we were proudly becoming a true multi-national company with upwards of 60% of our operating profit coming from outside the United States.

Had the duration and intensity of this perfect storm been understood at the time, I seriously doubt that anyone would have foreseen the situation we find ourselves in today. Company wide gross margins are up, not down. Overall EBITDA margins up as well to a very healthy 34%. Net free cash flow for the year approaching $100 million. Liquidity of approximately $400 million, despite our having repaid about $175 million of the convertible debenture due in mid 2010.

We have reached this juncture partly because of the fundamental soundings of our longer term business strategy, largely because of a tremendous team effort over the last 18 months, and very much -- very very much because Joe Wright has done a marvelous job of quarterbacking the game plan during that time. We owe a huge debt of gratitude to Joe, wish him the very best in his well-earned retirement and look forward to his continuing involvement on our board.

At the risk of being premature once again in our thinking, we believe that we have ridden out the storm and that we are poised to take full advantage of a recovery. The economic situation is far from robust but it’s moving in the right direction. We’ve just about flushed the full impact of the contract re-pricing through the system. The remaining question mark had been Italy but as Mike explained earlier, though there remain details to work through, this seems to have resolved itself as positively as we could have expected, at least from an income statement point of view. And as our share of earnings from abroad continues to increase, the dollar at least for now is moving back in the other direction with positive implications.

Over the course of the last several quarters, we have as Mike outlined a moment ago, been working quietly as well on a number of strategic initiatives that together with our core business will form the basis of our strategy going forward.

Most of you on this call, being of course the prudent investors that you are, are familiar with the acronym GARP -- growth at a reasonable price -- and you no doubt factor the concept into your own investment thinking. The strategy that Mike outlined a few moments ago is our own version of GARP, intelligent, sensible, strategically sound growth will continue to be a key element of our strategy but not at the expense of margins, cash flow, and balance sheet strength -- not to beat the literary analogy completely to death and with apologies to Sebastien Junger and John Irving, in effect we are at this moment moving from the perfect storm into our own world according to GARP.

On more than one occasion in the past, I have referenced Jack Welch’s idea that the real test of the management team is its ability to both grow and make money at the same time. Anybody can grow if they don’t have to worry about making money, Jack Welch has argued, and similarly anybody can make money if they don’t have to worry about growth. The real trick is the ability to do both.

And this brings me to our new chief executive, Mike Chambrello. Mike and I have been working together for close to five years now and I think I know him pretty well. And for what we are trying to do and the way we are trying to do it, I really don’t think there exists anywhere a more perfect chief executive for us than Mike. He is first and foremost a great leader and a great manager, admired and respected by co-workers, customers, competitors, and the financial community. He understands each of our businesses inside and out and he is pretty much a master of all the functions -- operations, technology, and in particular dealing with the marketplace. He knows how to plan and deliver growth but at the same time how to balance it with financial performance.

I know you join me in wishing Mike the greatest of success and hope that you share my unbridled enthusiasm for both Mike and for the future of the company. And now let me turn it back to Joe for a few wrap-up comments before opening up for Q&A.

Joseph R. Wright

Thanks very much, Lorne. Well, that’s our story for the third quarter of 2009. We pretty much did what we said we were going to do over the last several calls. I apologize like Mike does for the length of it but we had a lot to tell you this afternoon. I also hope that you feel that we have improved our transparency so that you are beginning to have a better understanding of our company, our results, and our goals.

Now, we’ll be happy to take any questions you may have. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Bob Evans of Craig-Hallum. You may proceed.

Bob Evans - Craig-Hallum Capital

Joe, sorry to see you leave. You’ve made great progress while there but Mike, congratulations on the new role. First can you clarify -- in your press release you talked about the Italy and the value-added tax is now excluded if you will in the new -- under the new contract but you had said it will be 20% of operating expenses. Can you give us kind of a clarification on what that means and will that be more profitable now than in the past?

Michael R. Chambrello

Let me take that one -- one, let’s just be clear that nothing has been finalized yet because the award hasn’t been made. However, there’s clearly an interpretation of VAT under the new tender which could result in increased profitability to the consortium in essence, given a reading of the VAT application under the new tender, it’s conceivable and quite possible that the actual rate itself might be slightly higher net fee slightly higher under the new tender than the old tender but I caution that at this point, nothing has been finalized and everything is subject to change. But that I think is the VAT issue that’s been floating around for the last week or 10 days or so and it could be reason for good optimism on all of our parts but premature to take it in hand and run with it.

Bob Evans - Craig-Hallum Capital

And Mike, when will you get greater clarity as if that’s the case?

Michael R. Chambrello

If that’s the case, I think when the process is completed and the actual contracts have been executed.

Bob Evans - Craig-Hallum Capital

Okay, and that should -- I believe a payment is due in November, so I would assume that’s in the relatively near future?

Michael R. Chambrello

Yeah, the payment right now the process calls for award of the contract on November 15th. It’s possible, I guess, that it could be sooner than that, and then the initial payment would need to be made no later than the 30th or 15 days post award.

Bob Evans - Craig-Hallum Capital

Okay and will you use existing -- well, assuming everything proceeds, existing cash on the balance sheet or how will you go at that balance sheet versus your revolver?

Jeff Lipkin

I’ll take that. As we just said, we just mentioned, we highlighted the liquidity position that we are in with $415 million of available liquidity, so I think we are comfortable with what our share of this up-front payment would be and we don’t comment on anything beyond that at this point.

Bob Evans - Craig-Hallum Capital

Okay, fair enough. And whoever wants to take this, your equity income line was maybe a little bit below where I had it modeled as it relates to the contribution you get from Italy and China. If you can maybe give a little bit more color, I think you have some currency impact there but just looking for a little bit more clarification as to your volumes were up but maybe the income, if you include contribution from China was maybe a little lower than I had anticipated.

Jeff Lipkin

I think as it relates to CLN, it’s largely FX. If you look at the exchange rate, the last quarter or same quarter last year was 1.55 and I think it was 1.42, something of that order. A lot of it had to do with FX related to CLN.

It’s hard to actually make a comparison obviously on CSG just given it wasn’t a joint venture last quarter but I think it’s kind of -- I don’t know what you are comparing it to but --

Bob Evans - Craig-Hallum Capital

Well, for CSG, can you give us any sense of what the magnitude of contribution was this quarter or --

Jeff Lipkin

I think it’s -- it will be in the Q obviously but it is still at this stage still pretty early in terms of the profitability. It’s profitable, I can tell you that.

Bob Evans - Craig-Hallum Capital

Okay, thank you. And then on the Powerball and Mega Millions, can you give us a sense of how big that online, that U.S. online business is and I know this is a big deal -- I’m just trying to get a sense of magnitude of what that might mean because I know incremental margins are high. I’m just looking for greater color there.

Michael R. Chambrello

You know, if you were to take the combined sales of both and again, Bob, this is -- you know, if you have a great jackpot run, it’s got one outcome. If you have a series of hits, it’s got another outcome but if you sort of take the historical perspective, you add the two together, you can expect in those two games a retail sales in the order of magnitude of 30% or so -- maybe a little higher but it’s hard to tell -- then I think you’ll be in the ballpark.

Bob Evans - Craig-Hallum Capital

Okay, so -- so potential retail magnitude of 30%. All right, thank you.

Operator

Your next question comes from the line of Carlo Santarelli of JPMorgan.

Carlo Santarelli - JPMorgan

I just had a quick question -- I know you guys gave some color on China and talked more bigger picture but if you look at retail sales last quarter and how they compared this quarter in the 3Q, what was kind of that level of change? And then if you -- could you kind of talk a little bit more about what you think might be some issues there or some things you want to work out near-term as it relates to the RMB20? Thanks.

Michael R. Chambrello

Well, again I think I outlined them in my comments. The three big issues are distribution, cash flow, and in the case of the third quarter it’s sort of really good news that we didn’t expect and we’ve got to overcome it is when the incentives were met in some provinces, they literally stopped aggressively selling, so we’ve got a program in place that we believe will turn that. We’ve got a longer term process project in place both for retail sales and cash flow, so I think that as I said this is the second turn but really the first full year that we’ve had sales in China and it didn’t recognize, nor did the CSL frankly, how much weight those incentives would hold. So I think we’ve got good plans in place that will help us drive through the balance of the year and in our goal setting and incentive setting for next year, we along with the CSL for a new marketing agreement and organization will be cognizant of these changes and we will be in great shape going forward.

Carlo Santarelli - JPMorgan

Mike, if you don’t mind if I could follow-up on that, I know you guys had set a retail sales goal for the year, what you thought the market could be and obviously I think a lot of us in our shoes were maybe growing off of that number for next year and the out years. Have you guys re-thought about that or is that number still pretty firm, that range still pretty firm?

Michael R. Chambrello

I think -- I don’t think we’ll be at the high-end of that range but I think as it relates to next year, we’ve just begun talking with the CSL and doing the data driven analysis that will get to a reasonable goal for next year, reasonable being very large by anyone’s standards in the world but reasonable I believe in China, so we don’t have a -- we don’t have a forecast yet. That won't happen until the very end of this year, probably our last joint visit to China sometime in mid-December.

Carlo Santarelli - JPMorgan

Very good. Thank you very much and congratulations.

Operator

(Operator Instructions) Your next question comes from the line of Larry Klatzkin of [Chaplain] Credit Partners.

Lawrence A. Klatzkin - Chaplain Credit Partners

Well, most of my questions have been asked -- I mean, again, the big question is you guys have spent some considerable time really consolidating, getting the company right-sized, getting costs down and the question is listen, you guys [have been at Global Draw], you’ve entered China, and a couple of other great initiatives that have really brought this company to new levels -- you know, what’s next as far as where you guys take this company? I mean, obviously there’s a lot of opportunities out there and I guess Lorne, I am sure you have been looking at all of them. Can you talk about anything as a direction you are looking to take it, or I assume it’s still kind of vertical integration kind of thing or even more out of the box like Global Draw or China?

A. Lorne Weil

I think Mike gave a good background sense a minute ago, Larry, on what we are thinking about and what we’ve been working on really for most of the last year in terms of developing new initiatives. I think it’s a little not very premature but a little premature right now to talk anymore other than to say as Mike explained it that we think we do have some pretty out-of-the-box stuff but it is out-of-the-box stuff that is very much in line and consistent with the fundamental strategic ideas and strategic guidelines that Mike talked about. You know, we’re going to stay close to the gaming business, we’re going to recognize the movement of the world more towards wide area, whether that means Internet, whether that means shops, whether that means mobile, where we see convergence of all these different segments so that the consumer has a choice across channels, focusing maybe on a brand and obviously as has always been important for us, the -- what we see, anyway, as the expanding role of either the government directly or government sponsored gaming, and I think within that a lot of the basic ideas, participation based revenue being critical, operating leverage, which obviously in the last few quarters has not been our friend but because of or thanks to the efforts of Joe and Jeff and Mike, we were able to blunt what otherwise would have been obviously negative operating leverage but now as we begin to move forward, I think that will be very important.

So really all I want to say now is that there are very exciting opportunities to mix and match these strategic ideas that Mike and I have just spoken about, which we feel certainly will give us all of the growth potential and the growth drive that we need to carry us forward in the next few years.

Joseph R. Wright

Now the company is really in good shape to be able to do that.

A. Lorne Weil

Absolutely.

Lawrence A. Klatzkin - Chaplain Credit Partners

No, I agree with that 100%. You guys -- Lorne, do you see any movement on privatizing of lotteries around the country, or is that kind of where the stop-off of the economy and everything, it’s kind of been waylaid for the time being?

A. Lorne Weil

Maybe I’ll ask Mike to answer that because really day to day, he is now much closer to what’s on the mind of the lotteries than I am.

Michael R. Chambrello

I think privatization, Larry, as we referred to it maybe a year or 18 months ago is on a backburner, so that you had a large up-front fee and in essence, the state gave up the rights to their lottery, you know, sort of on a lease basis. I think though that what we will see is an Illinois model where you have much, much, much more outsourcing in a highly private model so that the higher you drive sales, the greater the return to the state without in effect a large up-front fee. So I think we’ll see a variation of what was anticipated 18 months ago and I think we’ll see it sort of like you’ll see any new activity in this industry, whether it was Keno or monitor games or VLTs or others that you will see spots across the country where it will take hold and it’s very conceivable that some number of states in the next 12 to 18 months will go to a private model where in essence you have -- you know, think in terms of an operator model that you would be more familiar with in Europe than in the U.S. and significantly more controlled by the private operator than you would see today.

Lawrence A. Klatzkin - Chaplain Credit Partners

All right, well, good. Well, it seems like the right direction and I like the changes you guys did. Congratulations.

Operator

With no further questions in the queue, I would like to turn the call over to Mr. Joe Wright with closing remarks. You may proceed.

Joseph R. Wright

Okay, thanks very much. Lorne, do you want to make any?

A. Lorne Weil

No thanks, Joe.

Joseph R. Wright

You had one more comment for Larry.

A. Lorne Weil

No, I will save it to share with Larry privately.

Joseph R. Wright

Well, it’s about six o’clock. Sorry for the lateness and sorry for the length but again, we had a lot of content that we wanted to share with you. We hope you agree that we’ve had a very good quarter for considering the environment that we are in right now but we’ve made some tremendous progress and this company is as Lorne and Mike said, ready to grow and to grow responsibly and profitably. Thank you very much for being on the call. I appreciate it.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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