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Scientific Games Corp. (SGMS)

Q2 2007 Earnings Call

August 3, 2007, 8:30 AM ET

Executives

A. Lorne Weil - Chairman and CEO

Michael R. Chambrello - President and COO

DeWayne E. Laird - VP and CFO

Analysts

Celeste Mellet Brown - Morgan Stanley

Lawrence A. Klatzkin - Jefferies & Company

Ralph Schackart - William Blair & Company

Robert J. Evans - Craig-Hallum Capital Group

Carlo Santarelli - Bear Stearns

Amir J. Markowitz - JP Morgan

Todd Eilers - Roth Capital Partners

Presentation

Operator

Hello everyone. Thank you for joining us this morning. With us today are Mr.

Lorne Weil, Chairman and CEO and Michael Chambrello, President and COO and DeWayne Laird, CFO. During this call, they would discuss Scientific Games' Second Quarter 2007 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 remainder, this call is being broadcast live. Please refer to yesterday's press release for full details.

Before turning the call over to management, Scientific Games would for me 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 statements. For certain information regarding these risks and uncertainties, references made to Scientific Games annual report on Form 10-K for the fiscal year ended December 31, 2006.

Now, let's begin. Mr. Weil?

A. Lorne Weil - Chairman and Chief Executive Officer

Thank you, operator. Good morning and thank all of you on the call for joining the second quarter 2007 conference call. We have had a very active quarter to say the least and Mike Chambrello and DeWayne Laird are here to help me review the developments in some detail.

Today, I'll try to make my remarks uncharacteristically, and I suppose therefore, thankfully, brief in order to give Mike plenty of time to talk about all the things that he needs to talk about and still leave plenty of time for questions at the end.

I'll begin with a few observations from turning the quarter that may not be obvious from either the text or the numbers in the press release.

I think overall, we were pleased with the progress we made in the quarter. Revenue of $270 million was an all time record exceeding the previous record of $242 million that we reported in the first quarter of this year, and for the first time, our annualized revenue run rate was above $1 billion, which I guess is an interesting milestone.

Adjusted EBITDA of about $92 million together with the associated EBITDA margin of 34% were both records as well, and obviously we are pleased with those. The latter, which excludes non-cash stock option expense is a measure of profitability that I appreciate not everybody cares for, but it's the only one we think that allows bolt out [ph] comparisons to past quarters and fairly accurately measures cash generating ability of the business.

Reported EPS was $0.28 despite absorbing combined loses in OGT [Oberthur Gaming Technologies] and the Mexican lottery start up of about $0.03. And in addition, there was an impact of about of a penny due to the diluted effect of the convert shares even though the shares will never actually come into existence thanks to the hedge we purchased back when we issued them. That's another one of those accounting regulations, frankly, I don't understand, but that's the way the arithmetic works. So that would generate an EPS pro forma for the quarter of about $0.32. As Mike will outline in some detail in a few minutes, the Mexico and OGT conditions are certainly not ones that we would expect to persist indefinitely. And indeed, we are projecting very significant positive earnings contributions in the coming quarters from each of these business activities.

As mentioned in the press release, instant ticket service revenues grew 26% year-to-year and by 9% on a same-store basis. As also mentioned in the press release, the volatility of the MDI license revenue number seriously skews the data. If in fact we eliminate OGT from the '07 figure and the MDI revenue from both the '06 and '07 figures, then the growth of the Scientific Games instant ticket revenues per se was actually 19% in the second quarter, which I think is a much clear representation of what is actually going on in the core instant ticket business.

Normally we don't comment on what we expect to happen in upcoming quarters consistent with our position on guidance. But again, the volatility of the MDI revenue needs to be borne in mind as we move from the second to the third quarter. As we see it right now, MDI revenues will reach a record level in the third quarter, partially as a result of the timing of Major League Baseball games, but even more so due to the tremendous demand for new games like Deal or No Deal, which Mike will talk about in a minute and continued high levels of Major League Baseball demand.

Combined with growth in both the core Scientific Games and OGT instant ticket revenues, this could drive third quarter instant ticket service revenues to be ahead of last year by as much as 60% and by 30% excluding OGT. Instant ticket profitability also improved slightly in the second quarter, although this is not clear either from the reported numbers. Gross margin as reported went from $47.9 million or 47.6% of service revenue in '06 to $56.1 million or 44.2% of service revenue in '07. But if we exclude OGT revenue and gross margin from the second quarter, then the gross margin for the base Scientific Games business increased to about 48%, an improvement of nearly half a point over '06. From where we sit right now, we see no reason not to expect gradual improvement in this margin in the quarters ahead and again, Mike will address this in somewhat more detail in a minute.

In a moment, Mike will also discuss in some detail Lottery Systems, our progress in Mexico, the OGT integration and outlook, the situation in Germany and development of our business in China, which I know many of you have been watching very closely.

But before turning the program over to Mike, let me comment on the progress we are making with Global Draw, which is something again that we are asked about all the time.

As we have discussed previously, we have for the last several months, been in a very intense race against time to replace our entire installed base of legacy machines with the new dual-screen product, which we refer to as either the Nevada machine or the lotto [ph] machine depending upon our particular geographic location. The engineering, production, installation and test processes are very, very demanding, but it has done extraordinarily well and the machines and the associated system are performing flawlessly in the field in the UK. By September the 1st, we expect to have about 9000 Nevada machines installed and on that date, we will be permitted by the new regulations to throw the switch overnight that will allow every one of these to operate as either a traditional fixed

odds betting terminals or a new jackpot, very Nevada as it happens, slot machine like machine mode. No other supplier in the UK market is able to offer this feature which can be implemented remotely from the central server via the satellite network. The combination of this feature plus a lot of new proprietary content and the impact of the longer opening hours, which will begin on September the 1st, should drive we think rapidly growing machine income from September 1 onwards.

Excluding any potential business other than test sites that we might get from either of the two majors with whom we do not do any business at the moment, we expect to have well upwards of 10,000 machines installed in the UK by year end. And then any business that we do get from either of the two majors would of course be incremental to that as would any business that we get in Ireland, which we now feel is becoming a genuine opportunity.

As importantly, we are making excellent progress towards our goal of expanding Global Draw into the international market. And I can say right now that we are quite confident that over the course of the next year, we will install between 5000 and 10,000 machines in the Latin American and European marketplaces. I had hoped that we would have had some specific announcements to make in this regard by the time of this conference call, but I am quite confident that we'll be able to do so by the time of our next call.

This same confidence applies to the progress that we are making in the UK pub market through our Games Media subsidiary where the picture we are forming of the near term is becoming extremely positive. And I think by the time of the next conference call, we will be confident enough to make some machine forecasts for the pub market for next year as well.

And with that, I will turn the program over to Mike.

Michael R. Chambrello - President and Chief Operating Officer

Thanks Lorne and good morning everyone. As Lorne stated, we have had a tremendous amount of activity since our last call, so let me jump right into it.

As all of you are aware, a significant piece of our China strategy fell into place in July when we executed an agreement to acquire 50% of Guard Libang for $27.5 million. Many of you have expressed surprise at a relatively low price that we paid for 50% interest in such a significant company in the Chinese lottery market. While the dollar amount itself is significant, it represents only a part of the value that Scientific Games begins to this relationship. Our proven track record of successfully growing instant ticket sales around the world... Gratta e Vinci in Italy immediately comes to mind... was a significant factor in determining the overall value that Scientific Gains brings to this relationship. Specifically, the ability to drive sales by applying best practices learned during 30 plus years of experience in well over 100 lotteries worldwide were a major consideration in the overall evaluation of this opportunity.

Guard Libang has really done an excellent job of providing the infrastructure for instant ticket management, validation in sales systems and acquiring cooperative services contracts in 17 provinces and expanding into about 120 of China's most wealthy cities for the China Welfare Lottery. Specifically, Guard Libang is responsible for identifying and recruiting retailers in their contracted markets, instant ticket distribution and cash collection from retailers. It's also important to note that Guard Libang has a national contract with the China Welfare Lottery as their exclusive provider for instant ticket validation services to each of the CWL 29 lottery provinces. Clearly, SG's area of expertise, which include game design, security, retailer recruitment and sales and marketing strategy among many other things makes this combination a perfect match.

Maybe my most frequently asked question is how do we size this market? Well, given the early stage of the instant ticket sales life cycle, it's very difficult to do with a high degree of accuracy. However, if you consider that the population currently under contract by Guard Libang is almost 800 million people with a rapidly growing middle class, a retailer base conservatively estimated at just under 50,000 today and expected to grow to about 90,000 in the next 24 to 36 months, an ideal price payout of 65%, the ability and opportunity for higher price points and fees generally in the range of Germany and Eastern Europe, the foundation really is in place for our share of Guard Libang profits, profitability to rank in the top 2, 3, 4 contracts in the customers... in our company's customer portfolio probably in as little as say three years.

While Guard Libang is a significant piece of our overall China strategy, I want to emphasize that we continue to work very diligently on our China sports lottery activities as well. The Shandong contract, which we announced previously, continues to move forward and we are awaiting final approval for the specific games that will be available at launch. Once those approvals are received, we'll determine a specific launch date which will be later this year. Our progress on that project is going very, very well. At this time, China's sports lottery does not have the type of infrastructure in place that Guard Libang has implemented for the China Welfare Lottery. We believe there is an immediate term opportunity to provide infrastructure and cooperative services on a national basis for the CSL similar to those being provided by Guard Libang to the CWL. We'll keep you posted on our progress in this area in the coming months. It's certainly a significant area of our focus.

Finally, we continue to believe that the China market will require significant instant ticket production capacity expansion to meet the forecasted demands. We continue our discussions with the lotteries, local manufacturers and other affiliates to develop a framework that would provide tickets to the China market that possess really the same creative content, superior quality, security and integrity as those provided to our other Scientific Games customers worldwide. We really are very, very bullish on the China market. Our ability to identify the right partners, opportunities and infrastructure needed to create and maintain a tremendous growth market over the next decade is something we'll continue to pursue.

Moving on to one of our other key objectives, Germany, finally there has been some good news in Germany. And that is that the last of the states have ratified the monopoly lottery treaty to go into effect on January 1st of 2008. While we believe there will be some tinkering by the states prior to implementation, that tinkering will likely be pro-revenue generation which should, and I believe will, be conducive to adding additional cooperative services contracts for SGI in these German states.

Unfortunately, remaining doubts do relate to the EU threats against gaming monopolies of member countries, and the end result there is impossible to predict at this point in time, but we have seen some clarity and we are optimistic. We continue to work with a couple of key target states in Germany and hope to have constant news to report on at least one additional state by the end of the third quarter and possibly the beginning of the fourth quarter.

Mexico, sort of the third of the Big Three, as you saw from our press release, the roll out and branch profitability with Televisa is progressing at a slower rate than we had hoped. This really can be attributed specifically to three factors, all of which are a matter of timing.

Oxxo, the deployment of Oxxo retailers is behind where we had anticipated and hoped it would be by mid year. While Oxxo remains a very significant part of our long-term strategy, we'll be looking to more rapidly expand with instant ticket retailers... with independent retailers, sorry, geared towards the sale of instant tickets in the near term. These retailers will be clustered in the major metropolitan areas and can quickly grow to well over 1000 urban retailers by the time instants are launched while in parallel, we continue to expand the Oxxo retailer base.

Speaking of instant tickers, we hope that the launch of instant tickets would have happened early in the second quarter of this year. However, that launch has been pushed back to the end of this year, possibly in October or so, but we are focusing more on the end of the year at this point.

Also in Mexico, the televised bingo game, originally scheduled to launch in the second quarter, has been postponed until next year. We feel given the media strength of Televisa that this game has the opportunity to be a huge hit and we look forward to its launch possibly as early as the first quarter of 2008. We do remain very optimistic about the long-term prospects in Mexico. Keep in mind that it took about a year and a half from full implementation for Gratta e Vinci to take off and we see a very, very similar pattern in Mexico where we are just a few months into operation. We remain on the runway and may be there for the next quarter or two, but Televisa as our partner, with the strength of our offering, once fully deployed, the prospects in Mexico related to Televisa and other key strategic opportunities that we are pursuing in Mexico remain very, very positive. Like China and Germany, we view the overall Mexican market as a key to our long-term growth, particularly outside of North America, or outside the United States.

Staying with systems, continuing on with this group, I am pleased to report that the Connecticut conversion remains on schedule and in fact we are ahead of schedule in a number of key areas. I am extremely confident when this conversion is completed sometime next spring that it will be considered the gold standard for online conversions going forward, yet another testament to the amount of growth and quality in that group.

We continue to launch new online game content as we work with key lottery partners to reinvent the online product offering. Recent examples include a new Texas Hold'em style game in Maryland, which is that state's third successful monitor game following Keno and Racetrax where sales in both of those games in Maryland remained very, very strong. In May, Pennsylvania launched a treasure hunt game, which is based on a five digit, five number draw. A unique aspect of this game is that the drawing is actually shown via the Internet midday and is delivered via our RADDS system, which is a proprietary system.

Also early in the second quarter, the Kentucky Lottery launched the Multi-Hand Easy Win game to replace one of its existing games. It's interesting to note here that this game was launched in partnership with Kentucky where we are not the online technology provider, another example of the content value that SG brings to all customers in the lottery industry really independent of technology. Unfortunately, the jackpot draw continues, particularly in Powerball where we have not seen a good run that has had a positive impact on sales since very early in the first quarter of 2006. The current jackpot is $123 million and let's just hope it keeps rolling.

One other activity worth noting is the recent award of the online contract in the state of New Mexico to Intralot. We have remained committed to our strategy of only bidding on those contracts that we feel can add value where the lottery embraces a partnering relationship with a vendor focused on growing retail sales leading of course to increased returns to good causes where we have... and of course where we have a reasonable return on our investment.

By focusing on sales growth over a three year period from 2004 through 2006, top line sales of U.S.-based online lottery customers for Scientific Games grew at almost a rate of 12% compared to just under 4% for the rest of the industry, again, our focus on content and reinventing the content part of that business.

Back to New Mexico. In our view, it did not meet any of these criteria. So we just simply chose not to bid. In fact, the New Mexico price made up about 50% of the evaluation criteria, which demonstrates to us more of a focus on reducing costs than on growing sales. We estimate that based on a winning bid rate of about 1.5% and assuming extension options are exercised, the winning vendor will realize a rate of return of around 3% over the 10 year term. As anxious as we are to get the $2 a share run rate, and I am sure Lorne would agree, investing tens of millions in dollars at a low single-digit return is simply not the way to get there. We do remain very committed to the online market globally with a focused, disciplined and profitable growth strategy. And in fact, we are in the process of preparing a couple of online proposals at this time for submission later this summer, both of which will be benefited from our advanced system and new terminal development activities. I remain optimistic in this area, but again, we'll remain extremely focused and disciplined in our approach to that market.

Moving on to OGT, the merging of the two companies really is largely complete and we remain very optimistic regarding the impact this acquisition has had and will have on our customers in the future. We have completed our review and consolidation of SG&A, which has resulted in an annualized savings of about $5 million, an amount higher than our acquisition plan anticipated. We should begin to see these savings in Q3 and they will be fully rolled out and implemented in Q4. Also, following certain plant and equipment upgrades, further consolidation and optimization of other synergies, we will recognize total annualized savings of approximately $20 million beginning in the first half of 2008. By the end of the year, we will have completed our review and commenced implementation of our plan to rationalize production amongst our seven plants worldwide. This plan including the full deployment of our new press in Georgia will result in significant savings beginning in Q1 of 2008. We anticipate our worldwide capacity to approach 40 billion standard size tickets beginning in 2008, a dramatic improvement over the 25 billion or so of 2006 and most of 2007.

From our perspective and my perspective in particular, one of the most exciting opportunities that came together in Q2 relates to the continued success of MDI's Deal or No Deal property, which Lorne mentioned earlier. Beginning in Q3, we will have 31 North American lotteries offering Deal or No Deal in some form. The majority of these lotteries, 23 in fact, will be part of a nationally released game where the retail value of tickets offered will likely exceed $400 million, really incredible.

Just give you a little background on the game. Approximately 125 winners and 3 of your friends will be flown to Hollywood and actually play Deal of No Deal with Howey, the models and of course, the baker, just as if it was on the television show. In addition to their expense paid trip to Hollywood, each contestant will win $5000 to $25,000 depending on the suitcase they pick with a grand price of $1 million. This game is really a great example of our ability to expand the entertainment component of a traditional lottery game.

We believe there will be similar opportunities with other properties in the future in and Steve Saferin and his MDI team continue to do just a fabulous job in this area. This is the first time that this number of lotteries have been aggregated into one group for the purposes of selling an instant ticket game, but certainly not intended to be the last.

Finally, it's been a very busy and productive quarter related to instant ticket and cooperative service contract awards, so let me just list them for you very, very quickly. In Ohio, we received an instant ticket contract with a 2 year base and 6 years of extensions; Rhode Island, with a 3 year base and 3 years of extensions. Rhode Island is a brand new contract for SGI, so we are thrilled to have that in the family. Idaho, 2 year base with 6 years of extensions; again, another new contract for SGI and we are thrilled to be there. Connecticut, a long-term customer is a 3 year base with 2 year extensions. On the extension front, we received a 1 year extension in Oklahoma for online and CSP; South Dakota, we are fortunate to receive a 3 year extension. In Ohio CSP, which has bid differently and separately from the instant ticket mentioned above, we were granted a 2 year extension, and very recently, yesterday in fact, we were granted a one year extension in Massachusetts, one of our key instant ticket states.

So with that, and I apologize for the long report, but it's been an active and exciting quarter. I thank you and I'll turn it back to Lorne.

A. Lorne Weil - Chairman and Chief Executive Officer

Thanks Mike. That's a lot of terrific stuff, and I think it certainly speaks to the very positive outlook that we have for certainly as far as for the future as I can see. And with that, operator, we can open the program open to questions please.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from the line of Celeste Brown with Morgan Stanley. Please proceed.

Celeste Mellet Brown - Morgan Stanley

Hi guys, good morning.

A. Lorne Weil - Chairman and Chief Executive Officer

Good morning.

Michael R. Chambrello - President and Chief Operating Officer

Good morning.

Celeste Mellet Brown - Morgan Stanley

Just quickly on China, should we expect to see a loss flowing through equity income over the next few quarters or will you be positive?

A. Lorne Weil - Chairman and Chief Executive Officer

I think we'll really be breakeven. We might be slightly, slightly negative for a quarter or two, but I think we are really in pretty good shape there and ready for a nice launch into 2008.

Celeste Mellet Brown - Morgan Stanley

Okay. And then on the Global Draw, can you give us the installed base at the end of the quarter and also the margins?

A. Lorne Weil - Chairman and Chief Executive Officer

The installed base as of the end of the second quarter, Celeste?

Celeste Mellet Brown - Morgan Stanley

Yes. Or your expectations for the end of the third, if you want to share it?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, well, I think our expectation for the installed base at the end of the third quarter will probably be around 9500, 9600 in the UK, somewhere around there.

Celeste Mellet Brown - Morgan Stanley

Okay. And at the end of the second --?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, it will have been less than that, probably around 9200, some number like that, something like that. I don't have the number in front of me, but it's just a little over 9000.

Celeste Mellet Brown - Morgan Stanley

Okay. And then on the domestic business just first in 2Q, it looks like outside of the noise of MDI, it was a better quarter from a same-store perspective than we have seen over the prior two or three quarters.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, absolutely. Although I think the answer is yes in any case, but the only caveat is I don't think in any of the numbers that we've discussed in prior quarters, we went through the arithmetic of stripping out the MDI number so that we were looking at instant tickets go on [ph] instant tickers. I think even if we had, we would not have seen a same-store number as high as the one we saw in the second quarter. But I want to make it clear that we want to be sure we are comparing apples and apples.

Celeste Mellet Brown - Morgan Stanley

Right. So what do you think is changing that things are picking up in the second quarter?

A. Lorne Weil - Chairman and Chief Executive Officer

I'll let... Mike's really close to that day to day than I am. I'll let them try and answer it.

Michael R. Chambrello - President and Chief Operating Officer

Yes, we have had... Florida has had a really great quarter, Georgia has had a really great quarter, Pennsylvania has been solid. Just I would say, Celeste, just really overall strength but driven by particularly Florida and Georgia.

Celeste Mellet Brown - Morgan Stanley

Okay. And then Lorne, you spoke very casually of 60% growth in the instant ticket business for 3Q.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes.

Celeste Mellet Brown - Morgan Stanley

Can you give us a little more color there, and I understand you are excited about some of the products, but just give us a little more color on how you get there and maybe whether or not that's the higher or lower margin business?

A. Lorne Weil - Chairman and Chief Executive Officer

Sure. Well, again, we have to decompose it. I think it will be 60% or maybe even a little more than 60%, if you take OGT out because OGT wasn't in the third quarter of last year. So if you take the OGT sales out, it would come down to about 30%, which is still a higher number quarter-to-quarter than we have seen in ages. But now that 30%... just to make sure I am confusing everybody as much as I possibly can... that 30% again does include MDI. And as Mike said, MDI's sales are just booming and the third quarter, as I said in my remarks, will be by a significant margin the biggest quarter we have ever had in MDI. So if you want to invoke the principle of insufficient reason, I would say it's about in equal parts due to OGT, MDI and then the very strong growth in the core business as Mike was talking about a second ago.

Celeste Mellet Brown - Morgan Stanley

And then in terms of the margins on that business, I guess the share volume should drive them probably higher than normal except for OGT?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes. Although I mean I think, yes, OGT's margins should improve meaningfully in the quarter to not to where they would approach ours, but they'll be certainly considerably higher than they were in the second quarter. So that's still going to have a positive impact on the average. So yes, I think it's hard to imagine any other result.

Celeste Mellet Brown - Morgan Stanley

I am sorry, one more annoying question for you.

A. Lorne Weil - Chairman and Chief Executive Officer

Your questions are never annoying.

Celeste Mellet Brown - Morgan Stanley

What was the spread on the gross margin side between OGT and the core business this quarter?

A. Lorne Weil - Chairman and Chief Executive Officer

Give us one second and we can tell you that exactly.

Celeste Mellet Brown - Morgan Stanley

Okay. If you want to take someone else and come back to it, that's fine.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, the difference between OGT's gross margin and our gross margin in the quarter was about 25 points.

Celeste Mellet Brown - Morgan Stanley

Okay. Thank you very much.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes.

Operator

Your next question comes from the line of Larry Klatzkin with Jefferies. Please proceed

Lawrence A. Klatzkin - Jefferies & Company

Good morning. It's always nice to follow Celeste. A quick question here. As far as Games Media goes, I understand that as the law changes, you have some unique offerings for the market. You have a combination of three machines, a gaming machine, a quiz machine and a jukebox. What are your prospects? How do you think the business [ph] is going to be seen and what kind of potential you can see in Games Media here if this really takes off with, what is it, 100,000 pubs around the country?

A. Lorne Weil - Chairman and Chief Executive Officer

I am trying to think of a cautious, very modest answer, but actually the way you posed the question, I can be a little bit expansive and I think I could say that with a couple of breaks because the market is so big and the opportunity of converting it to the business model that we are working on. And I think at this point, Larry, you understand that business model pretty well. I don't think actually... I think it's possible that in quite a short period of time, we could build a business in the pub market as big or bigger than the one that we have in the betting shop business. And that's certainly what we are looking at right now as we are putting our business model and our business plan together.

Lawrence A. Klatzkin - Jefferies & Company

Basically, what they are going to have is so revolutionized compared to what they have right now, your offering between the jukebox, the quiz machine, the slot machine that it could change them completely and how they look at this?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, I mean what we are hoping is if you go back in time, gaming was a very important component of the profit equation of pubs. And over the last several years, for a whole variety of reasons, the contribution that gaming makes to the profitability of pubs has really, really eroded. And as it has eroded, it obviously has eroded the profitability and the effectiveness of the pub business itself. Now there is clearly an opportunity to effectively flip a switch and put the contribution of gaming back to where it was kind of in its heyday. And that in turn is, I won't say a cataclysmic impact on the pub business, but certainly as great an impact on the pub business as the FOBT has had on the betting shop business. And if you have done any analysis of that business, you know that with the impact of the latter, it's been extraordinary.

Lawrence A. Klatzkin - Jefferies & Company

The pubs are made up of big chains, so I would expect your guys goal would be to try to get one or two of those chains to just test yours. And if successful, you could end up with thousands of machines with relatively little effort because you are going to get one organization to put it throughout their system. Will that be... that is the potential you have?

A. Lorne Weil - Chairman and Chief Executive Officer

I think that's substantially right. I don't think any major organization, at least in the near term, I don't think it's reasonable for us to expect that they will put it throughout their entire organization. But I think it's quite reasonable to expect and in fact, we are working on contracts that have language that is specific in these terms that they would put it in a deliberate percentage of their locations, let's say, a third. But again these... whereas in the license betting shop business the largest operator has 2000 shops. In the pub business, the largest operators have many, many, many, many times that many shops. So one third of a couple of big pub operators, and you are talking about a number of machines that dwarfs what we do in the betting shop business.

Lawrence A. Klatzkin - Jefferies & Company

So, obviously, you are not going to answer this straight out, but if things go right and the pub businesses reaches its potential, you could be looking at $30 million, $40 million longer term of EBITDA out the Games Media business, which right now is literally nothing?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, you wouldn't... yes, as you said, you would not expect me to answer that directly.

Lawrence A. Klatzkin - Jefferies & Company

The second question is before the fifth machine at the Global Draw side, I was there recently and I saw that on a lot of the shops there is this kind of a Global Draw board in the normal screens, which was a proprietary game of you guys. So it's not a separate machine, but it's an additional game. How does that work? And I understand you have some products rolling out on that, and what kind of potential?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes. We call that... generically, we call that Global Plus, the first big roll out of that is actually taking place as we speak in all the Coral shops where we and they call it Coral Plus. And the idea is this: the regulations limit the betting shops to 4 freestanding betting machines, which in the UK, they call fixed odds betting terminals. What we have done is we put a big, really big flat screen, and the goal eventually is to have them not only in all of the Coral shops, but ideally in every shop in the UK. Very much like the screens that we use for the monitor games in the states. If you were, for example, to go down to Maryland and go on to a bar or a tavern down here, you would see our horse racing game and our Keno game in that most recently we just launched in Maryland a Texas Hold'em poker monitor game. And it's very similar to what we are doing in the UK. The idea is if we can put in a screen, and with that big screen as many players can play those games as want to just like as at a pub you have one monitor screen, but you might have 50 people in the bar betting on the Keno games or the horse racing game or the Texas Hold'em game. And that's the idea in the betting shop because with only 4 fixed odds betting machine, you can't kick somebody off. So once 4 people sit down at the 4 machines, that as many people as can become involved in gaming. But now with this new monitor system, another 100 people can be betting at the same time. And so we are very, very optimistic and hopeful about this.

Lawrence A. Klatzkin - Jefferies & Company

As far as outside the UK, you've just removed 9200 machines out of Global Draw.

A. Lorne Weil - Chairman and Chief Executive Officer

Right.

Lawrence A. Klatzkin - Jefferies & Company

And you said you guys had written those off when you bought the company.

A. Lorne Weil - Chairman and Chief Executive Officer

Right.

Lawrence A. Klatzkin - Jefferies & Company

What you are going to put in the other countries like Mexico, Puerto Rico, whatever, are those going to be new machines? Are those going to be the written-off machines, which means no depreciation, no further expenses?

A. Lorne Weil - Chairman and Chief Executive Officer

It would vary from country to country. The test that we have undergoing right now in Mexico was actually in the Nevada machine, and if as we hope the test is successful and we begin a roll out, they would be the new style machines. But that's... certainly there are other markets in Latin America where the... I referred to earlier as the legacy Global Draw machines would definitely have a market. And indeed in some of these markets, for a variety of reasons, it's actually something they prefer. At the time that FOBTs were originally installed in betting shops in the UK, they didn't want something that looked like... that was obviously a slot machine. They wanted something that looked really more like a kiosk that happened to play games instead of selling train tickets. And there are many markets where, because of where they are in their evolution, they are of the same mind. So we think that we are going to have a very good market for most, if not all, of the 9000 machines that we have now taken out of Global Draw. And as you probably know, we were in the process in our plant in Ireland of basically refurbishing every one of those so that they look and feel like they are brand new. But as you said, they have actually been written off our books. So any incremental revenue they generate in new markets is really pure profit.

Lawrence A. Klatzkin - Jefferies & Company

Next question. I am sorry I'm taking so long. China, I mean if you get going in all 17 provinces plus the other one you have, I don't know if the production existing in China today can really handle that. I know you are getting a separate fee with the first province for making the tickets. Is there potential for building a plant in China and could you, or throughout Welfare, end up getting a fee for making tickets also and is that additional profit center for you?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, I think at the moment Mike is probably considered the authority in the world on the issue of lottery ticket production past, present and future in China. So I'll let him answer that.

Michael R. Chambrello - President and Chief Operating Officer

Well, Larry, you are absolutely right. The production capacity does not exist in China today to meet when we forecast next year's requirements and certainly the mid to end of next year. So there is clearly going to be a requirement for significant expansion of capacity in China either to existing printers and new printers. And we are certainly in the middle of that and in the mix. And if you are providing instant tickets in addition to the cooperative services type arrangement, then there would be an additional fee similar to the Shandong deal that would happen in many of these other... in each of these other provinces as the model is unfolding. So that's a significant part of the overall strategy.

A. Lorne Weil - Chairman and Chief Executive Officer

Operator, I think you can take the question from the next caller.

Operator

Yes, you next question comes from the line of Ralph Schackart with William Blair. Please proceed.

Ralph Schackart - William Blair & Company

Good morning. Lorne, it seems like the Global Draw is a very exciting opportunity in very near term. Obviously, you are able to increase the number of units, the duration of game play is going to increase. I was wondering if you could help us, without quantifying it, or I guess if you wanted, that would be great, just help us understand the order of magnitude difference on the revenue opportunity with the new content?

A. Lorne Weil - Chairman and Chief Executive Officer

It's really impossible to answer that Ralph because it's not really all going to start until September 1st. And nobody really knows. I think rather than try... I mean it cannot be positive that unless you made the argument that the introduction of new content sufficiently confuses the players that they decide to go home and not play at all. But I mean that's... other than that, it cannot be positive. But how positive, I would really just rather wait till the next quarterly call because by then we will have had a couple of months of experience and we might be able to talk about it more intelligently.

Ralph Schackart - William Blair & Company

Great. And Lorne, as you know, the real special businesses out there are ones that could increase returns on capital and continue to return the cash flow back and so increasing returns. And to date, you've enjoyed that type of business model. As you look over the horizon, pick your duration, three plus years, do you think you're going to continue to have that luxury in that type of business model and how do you balance that against the acquisition opportunities that you see over the horizon? Thanks.

A. Lorne Weil - Chairman and Chief Executive Officer

Well, I think as long as we stay innovative and do a range of things that we think we are able to do to not allow the main markets that we address to commoditize, then I think we can continue to see the kinds of increasing returns that we've seen and continue to grow with incremental profitability and incremental return on investment. But again, we have to keep spending money to do that and we have to keep spending money in an innovative way to do that. As far as the issue of acquisition opportunities, we are on the one hand, we tend to think very strategically, but on the other hand, we are very opportunistic and if something suddenly falls into our lap that's smack in the middle of our sweet spot, we know that in a business like ours, you can't say well, this is very interesting, could you come back in a couple of years. You've either got to be ready and able to move right then and there or miss the opportunity. And at least our record and our experience has been that to my knowledge we have never let something that we really wanted to slip by because we were either distracted with something else or worried that we had too much debt on our balance sheet or didn't have enough human resources to have... we never have enough human resources to do all the things that we are doing around here. But our plan is to keep on moving down those two tracks and we are confident that we can continue to do that.

Ralph Schackart - William Blair & Company

Great. Thanks Lorne.

A. Lorne Weil - Chairman and Chief Executive Officer

Sure.

Operator

Your next question comes from the line of Bob Evans with Craig-Hallum Capital. Please proceed.

Robert J. Evans - Craig-Hallum Capital Group

Good morning gentlemen.

A. Lorne Weil - Chairman and Chief Executive Officer

Hi Bob.

Robert J. Evans - Craig-Hallum Capital Group

Hi. A couple of detailed items. First on the Global Draw, just can you give us a ballpark sense of how big that business, the betting shop business will be this year? Just trying to get a sense of the magnitude of what games might be, and I'm trying to make sure I understand growth rates.

A. Lorne Weil - Chairman and Chief Executive Officer

You do mean for us?

Robert J. Evans - Craig-Hallum Capital Group

For you, yes.

A. Lorne Weil - Chairman and Chief Executive Officer

Well --

Robert J. Evans - Craig-Hallum Capital Group

Ballpark.

A. Lorne Weil - Chairman and Chief Executive Officer

Ballpark figure, it should be about 25% bigger that it was... than it would have been annualized last year, if I am being sufficiently evasive in it [ph].

Robert J. Evans - Craig-Hallum Capital Group

As I expected. Okay, that's fine. That gets me close enough. And how about MDI? I am again, trying to get a sense of how big that is in magnitude of growth?

A. Lorne Weil - Chairman and Chief Executive Officer

Probably around same actually, the same [indiscernible] relationship.

Robert J. Evans - Craig-Hallum Capital Group

I mean is it possible to get more of a raw number there? I have got to go back through my notes, but I am trying to figure out how much MDI has to grow to account for the level of growth you are talking about in Q3.

A. Lorne Weil - Chairman and Chief Executive Officer

I think... well, I think in Q3, we are anticipating revenue from MDI between $25 million and $30 million.

Robert J. Evans - Craig-Hallum Capital Group

Okay. Which I assume is the biggest quarter that you'll have ever had.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes.

Robert J. Evans - Craig-Hallum Capital Group

Okay. And then the other part of the 60% gross... growth that you had referenced was from OGT?

A. Lorne Weil - Chairman and Chief Executive Officer

Right.

Robert J. Evans - Craig-Hallum Capital Group

Okay. And OGT --

A. Lorne Weil - Chairman and Chief Executive Officer

And whatever is left would be the core instant ticket base... for Scientific Games instant ticket base.

Robert J. Evans - Craig-Hallum Capital Group

Right. And as we look at the margin differential between OGT and the traditional business, can you close that gap to where OGT can get to up to the corporate average or do you expect it to always be somewhat of a drag?

A. Lorne Weil - Chairman and Chief Executive Officer

There is no inherent reason why it shouldn't at some point equal our corporate average. I mean it's going to move in that direction asymptotically. When it's going to get there is a little bit difficult to say, but there isn't... I'll put it this way, the only reason why it would not in the fullness of time be able to get to a gross margin level that was comparable to our average is if we left it with a manufacturing infrastructure which was not up to the state of the art as the rest of the company and then by definition, it wouldn't be able to achieve the same level of margin. So that isn't... our intention in the fullness of time is for every single factory we have operating in the company to be producing with state-of-the-art equipment and state-of-the-art technology. And if indeed that's the case, then I think the margins would be comparable.

Robert J. Evans - Craig-Hallum Capital Group

And Mike, to discuss what you had mentioned earlier on the 20, I believe you said by early '08, we should be able to see $20 million of savings annualized on OGT through efficiencies and cost cutting and everything else?

Michael R. Chambrello - President and Chief Operating Officer

Yes, I would see that in the beginning in the first half, not very early '08. And again, to complement what Lorne is saying, we'll realize those savings, but to really get the margins to where we want them to be, there is quite an equipment upgrade that will have to be put in place, and that obviously takes a little bit longer.

Robert J. Evans - Craig-Hallum Capital Group

Okay. So there is room beyond that $20 million that you are talking about to get --

Michael R. Chambrello - President and Chief Operating Officer

Yes, absolutely. Yes.

Robert J. Evans - Craig-Hallum Capital Group

Okay. And just one cash flow item. On the D&A, the D&A jumped sequentially a little bit more sharply. Do you have... is that a sustainable... I assume that's for that OGT acquisition, but can you tell us how much of that jump is amortization of intangibles?

A. Lorne Weil - Chairman and Chief Executive Officer

I don't think that there is much of that increase that relates to amortization of intangibles. It's the capital that's been deployed in Mexico, it's the new contracts deployed and it partly relates to capital deployed now on Global Draw as we roll out the new Nevada term [ph].

Robert J. Evans - Craig-Hallum Capital Group

Okay. DeWayne, if I can follow up with you just to get whatever number that is on amortization, I'd just --

DeWayne E. Laird - Vice President and Chief Financial Officer

Sure.

Robert J. Evans - Craig-Hallum Capital Group

I would like to keep track of cash EPS estimate. Thank you.

Operator

Your next question comes from the line of Carlo Santarelli with Bear Stearns. Please proceed.

Carlo Santarelli - Bear Stearns

Hey guys. I just want to know where do we stand right now on the sports betting initiative and kind of what's your thinking about that going forward?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, sports betting initiative is kind of a two-pronged thing. In Europe and other... or let's say Europe and Asia, it is really part of our lottery initiative because that's how the sports betting business in much of Europe as we see it is unfolding. So we have done... we have our original European sports betting system deployed with 16 lotteries in Germany, we have gone into Switzerland, we are just about to launch a really terrific system I think at Greece [ph], as state of the art as it gets in Norway, and I think that business moving forward nicely. And in North... let's say North America... in the Americas, the business opportunity is a slightly different one. It providing a turnkey technology, equipment and service very similar to what we do in the racing business, but to operators of horse races who in many cases are also racing customers. And the situation we have there is we have tremendous demand for that service, far more demand than we are at this moment in time generating revenue. And the sticking point in terms of moving forward has to do with certain issues in the racing business that are being worked through right now because as I said a second ago, virtually 100% of the sports betting turnkey service operators are also racing service operators, an they want a completely integrated package. And we are having to resolve some issues that have to do with, let's just say, the peculiarities of the racing business in the United States. We're getting very close to that, and once we get this all worked out, I think this sports thing is going to take off and so come off the runaway very fast. And I apologize if that's all a little bit cryptic, but there are just some things that I really can't talk completely about, but we are very well along in working the --

Carlo Santarelli - Bear Stearns

Okay, great. And then I guess is there... there is obviously this prevalent study going on in the UK. Do you guys feel there is any I guess risk towards any of the Global Draw, the FOBT machines? Does that pose any kind of risk for you guys?

A. Lorne Weil - Chairman and Chief Executive Officer

We don't think so. Whatever risk it poses to us, it poses approximately 10 times that risk to Carl's Hills [ph], Ladbrokes and several thousand other bettings... the total... and so forth betting shops in the UK. And I think they're pretty focused on let's say minimizing any risk that this would have to their business and whatever happens to us would just really be kind of a secondary consequence.

Carlo Santarelli - Bear Stearns

Okay. And lastly, just a quick model question. If you could tell me would maintenance CapEx or CapEx and wagering system expenditures in the quarter as well as cash from ops, do you have any of that stuff?

Unidentified Company Representative

Well the CapEx in the quarter was $55 million.

Carlo Santarelli - Bear Stearns

Okay. All right, great. Thanks.

A. Lorne Weil - Chairman and Chief Executive Officer

Sure.

Operator

Your next question comes from the line of Amir Markowitz with JP Morgan. Please proceed.

Amir J. Markowitz - JP Morgan

Hey, good morning. Just two quick questions. You guys mentioned that Oxxo installations were lagging a little bit. Can you discuss a little bit why and if you think it's going to accelerate within the next 6 to 12 months or so?

A. Lorne Weil - Chairman and Chief Executive Officer

Mike will answer that.

Michael R. Chambrello - President and Chief Operating Officer

Yes, it's... Oxxo was actually very regimented and very standardized in how they implement new hardware into each of their locations. And the "acceptance testing" on a location-by-location basis I have to tell you is more rigorous than anywhere I've ever seen anywhere in the world for any point of sale device. So that is the primary reason. And part of the reason is there has been a slowdown in the summer, which we probably should have anticipated, but not to the degree that maybe that's happened. But yes, we do expect over the next 6 to 12 months Oxxo to continue to grow and make up a significant overall percentage of that retailer network.

Amir J. Markowitz - JP Morgan

Thanks. And the second thing was you guys are talking about pretty significant growth in the instant ticket business in the third quarter. Now is there anything that's kind of one time or is there something kind of fundamentally changing in instant ticket business that can make not 60% growth, but higher than we've seen kind of in the past, or at least in the past few years going forward?

Michael R. Chambrello - President and Chief Operating Officer

Well, obviously, the inclusion of a full quarter of OGT revenues is one time.

Amir J. Markowitz - JP Morgan

Right. Aside from that.

Michael R. Chambrello - President and Chief Operating Officer

Apart from that, we had the second quarter in MDI was a little bit lower than where it should have been just because of the way that some of the Major League Baseball revenues fell. So part of the MDI growth in the second quarter and the third quarter is in effect the catching up in the third quarter of Major League Baseball business that we had otherwise expected was going to happen in the second quarter. So I think you could legitimately say that that was a one-time event because obviously we can't grow forever by sloshing revenue back and forth. But [indiscernible] the end of year it still adds up to whatever it adds to.

But then I think the rest is genuine growth in the core instant ticket and genuine growth in the licensed product business. I think the real thing that you need to grasp here is that for some time the organic rate of growth of our licensed product business has been far greater than the underlying growth of the instant ticket business even in those years when the instant ticket business was growing well into the double digits. There is nothing really to constrain the growth of the licensed product business other than how creative we can be in imagining new opportunities and the risks that we are willing to take to nail these deals down. We have, as you probably know not long ago, and in very intense competition, we were able to make a deal with has Hasbro to have an exclusive license for every Hasbro brand in every lottery distribution channel in every country of the world. And for that, we committed our self to minimum royalty commitments that three or four years ago nobody in the lottery business in their right mind would ever even thought about doing.

So as long as we... the same went for Major League Baseball when we first did that. So I think there is plenty of things that we can do to keep our revenue growing at a rate that we are happy with and hopefully, these kinds of things also... I said these a few times before, but if I haven't to you, by our calculation, in the last three or four years, about 35% of all of the growth in instant ticket, unit instant ticket sales or retail instant ticket sales in the United States has come from the growth of license games. The license game retail sales have grown from about $200 million a year in 2003 to, we would expect, maybe as much as $3 billion in 2007. So that's... I don't know what that compound growth rate is, but it's very high.

Amir J. Markowitz - JP Morgan

Okay. Thank you.

Operator

And your final question comes from the line of Todd Eilers with Roth Capital. Please proceed.

Todd Eilers - Roth Capital Partners

Hey guys, how are you?

Unidentified Company Representative

Good.

Todd Eilers - Roth Capital Partners

Most of my questions have been answered, so I will be just quick here. I just have one quick modeling question. It looks like in your lottery systems business the prior year, it looks like you might have reclassified some revenue there around $7 million from service to sales.

Unidentified Company Representative

Yes.

Todd Eilers - Roth Capital Partners

Just wondering what went on there and should we expect any more of that going forward?

Michael R. Chambrello - President and Chief Operating Officer

Yes... no, you exactly right. It was a mistake. Effectively, it was a mistake in reporting in the prior quarter. What happened was I am not sure what 7. 8... whatever... let's say with $7 million, $7.4 million to be exact of terminal sales clearly one-time terminal sales in Europe were erroneously reported as service revenue. And we have recently discovered that and reclassified that into where it should have been, which was one-time sales.

Todd Eilers - Roth Capital Partners

Okay, that's all I had. Thanks.

Michael R. Chambrello - President and Chief Operating Officer

Yes.

A. Lorne Weil - Chairman and Chief Executive Officer

Okay everyone. Well thanks for dialing in. Thanks for your continued support and we look forward to speaking to you in a quarter where we are hopeful that we will have a number of very positive interesting new developments to report, and I am sure we will have a few interesting things to report along the way too. So thanks again and everybody have a good weekend.

Operator

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

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Source: Scientific Games Q2 2007 Earnings Call Transcript
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