Scientific Games Corp. Q1 2008 Earnings Call Transcript

| About: Scientific Games (SGMS)

Scientific Games Corp. (NASDAQ:SGMS)

Q1 FY08 Earnings Call

May 9, 2008, 08:30 AM ET

Executives

A. Lorne Weil - Chairman and CEO

Michael R. Chambrello - President and COO

Analysts

Lawrence A. Klatzkin - Jefferies & Company, Inc.

DeWayne E. Laird - VP and CFO

Celeste Mellet Brown - Morgan Stanley

Ralph Schackart - William Blair & Company

Steven Kent - Goldman Sachs

Robert J. Evans - Craig-Hallum Capital Group

Operator

Hello everyone. Thank you for joining us this morning. With us today are Mr. Lorne Weil, Chairman and CEO; Michael Chambrello, President and COO; and DeWayne Laird, CFO.

During this call, they will discuss Scientific Games first quarter 2008 financial results followed by question-and-answer period. A replay of this 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 yesterday's press release for full details.

Before we 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 Litigations 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, reference is made to Scientific Games annual report on Form 10-K for the fiscal year ended December 31st, 2007.

Now let's begin. Mr. Weil, you may proceed.

A. Lorne Weil - Chairman and Chief Executive Officer

Thank you, operator. Good morning everyone, and thank you for dialing into our first quarter conference call. As the operator said, DeWayne is here with me in the office in New York, and Mike Chambrello is actually at our facility in Harrisburg, Pennsylvania, from where, in a few minutes, he will address a number of important issues including the one that he happens to be dealing with personally in Harrisburg.

I've lost track of exactly how many of these conference calls I've done, but I think it must be something over 60 at this point. As many of you will have recently read, I expect to do just two or three more and then hand the baton over to Mike and Joe Wright [ph], whom I know will pick things up without missing a beat and they will do at this rapidly becoming the most exciting time in the history of the company by far.

During the course of these 60 plus conference calls, you have heard me say many things never go in straight lines especially in a business like ourselves where major developmental opportunities come in very large lumps, and where timing is often to a great extent beyond our control. And of course, neither of these characteristics is always for the liking of the investment community, and also I might add it's one of reasons that we don't give formal guidance.

Looking out over a three or four year time horizon, we can usually be pretty confident that we'll get it from the starting point A, to our intended destination at point B, but where we can only forecast the precise itinerary, though as it is often the case, we can do point out when at certain moments in time we think we might be temporarily above or below the expected longer term trajectory.

Occasional uncertainty regarding our exact heading may not always be for the faint of heart, but as I will talk about in a few moments, this is a pretty good vehicle to be on when storm clouds are gathering. In the mean time, our job is to effectively and tenaciously commit financial and human resources to technology, production content, product of long-term market development in very carefully chosen segments of the overall industry. And then patiently wait for the strategic hands to play themselves out. And most of the time, as is certainly the case at the moment, they do. Because with respect to the major initiatives, we have been aggressively pursuing for the last three or four years, I can tell you confidently that we are very rapidly approaching point B much faster than might have been understood even 90 days ago and that we expect this to become much clearer over the course of the next few quarters.

As projected during our last conference call, the first quarter of 2008 shows strong sequential improvement over the fourth quarter of 2007. Reported EPS was $0.21, up from $0.17 in the fourth quarter. If we add back the phone card severance charge in global draw earn-out expense the apples-to-apples EPS is about $0.24 or about 41% ahead of the fourth quarter sequentially. And it should be pointed out that this figure continues to include a loss of about $0.02 in Mexico, which had not yet existed in first quarter 2007. And in previous quarters we have considered to be an add-back, because this was essentially a start-up operation. But at this point, we are incorporating the loss into the $0.24 profit.

Revenue in the first quarter declined sequentially from the fourth, but this was due largely to the instant tickets that we produced and shipped to China, but not recognized as revenue. As we will discuss in a moment, we expect second quarter 2008 revenue to far exceed revenue in the second quarter of last year or the first quarter of this year and indeed to set a revenue record for any quarter in our history.

As we are coming closer to completing the integration of OGT during the first quarter, printed product gross margins returned to within one percentage point of pre-OGT levels after running well behind for three quarters of last year. It was not until February, that we closed the doors on San Antonio and no longer had any payroll responsibility and it was not until March that our lease with the prior owners was done and along with it certain associated facility overheads. It was also in February that we relocated all production from the legacy Honda facility in Germany to Leeds and the facility converted to the operating headquarters of the German Cooperative Services Business.

As mentioned in the press release, we took a $2.8 million severance charge to restructure phone card manufacturing and as Michael will explain in a moment, this will have a very positive payback in coming quarters. Michael talk as well about the tremendous launch that we have had in China, and our plans for adding very substantial production capacity there.

Our original plan had been to take delivery of a press in China at or slightly after year end, but a few weeks ago we were notified that a competitive press order had been canceled with Midstream and by making an immediate purchase commitment to it, we now expect to have a press arrive in China much earlier.

Given the trajectory of the launch, as Michael will describe in a moment, potential excess capacity is least of our worries, although we do of course always have the option of exporting tickets from China where we expect to have a very favorable cost structure.

The Lottery Systems Group had another very strong quarter financially. It was to say the least, a quarter filled with excitement. After awarding its online contract to a competitor in January, the Pennsylvania Lottery subsequently announced that it was suspending contract negotiations and instead going to quote best and final process. And at the end of the process, we were asked to participate in contract negotiations. Mike, myself and key members of our team initiated this process with the lottery last week. Mike is continuing with this week and we will hopefully have more to report in the relatively near future.

Also, during the quarter we were given a nine-month contract extension in West Virginia, following our protest of an award to a competitive in that state. The wisdom of the Global Draw strategy and the excellence of its execution by the Global Draw team began to become clear during the first quarter. Months after months, the Global Draw U.K. business continues to set performance records despite the apparent slowing down of the U.K economy, the general weakness in the U.K. gaming sector and an impact of the U.K smoking ban on competitive gaming venues.

Driving this performance is a combination of competitively superior hardware and software, a satellite communications network that is very cost effective and almost infinitely scalable, very high quality field service and excellent proprietary content that in fact has began to build a very important secondary market with other gaming manufacturers with whom we do not directly compete.

We are making excellent progress outside the U.K betting shop sector as well. The performance of our installations in Mexico has been tremendous and we anticipate a steady increase on our installed base of machines and associated profit stream as well as the broadening of our customer base in Latin America.

At some time within the next two quarters, we expect to launch systems in two important Central European countries. And our games and media U.K pub strategy driving a shift in the market from standalone analog machines to network server-based digital product is proceeding according to plan.

As mentioned a few moments ago, we expect to achieve record revenues in the upcoming second quarter and we do not at this point see any deceleration as we move through the rest of the year. With that, that our business is performing at this level despite the way you reason the environment that include rising unemployment, the mortgage and housing situation, the price of gas and so forth, is we think a reflection of the deliberate strategic architecture that underlies our business.

Indeed ironically, many of the factors that both make our business difficult to forecast and therefore try the patience of the research community are indeed the very factors that so effectively insulated against outside economic fortunes.

I know I've communicated these ideas many times before, but given the current environment, I think it's worth reiterating the major strategic themes. Maximizing the proportion of our business that comes from multiyear recurring revenue contracts in order to minimize competitive pressure during weak economies, emphasizing participation based contracts so that we can drive our revenues by helping our customers drive there's, maintain a strong component of government sponsored gaming since for several reasons, this tends to be inherently counter cyclical; minimize exposure to destination gaming markets, which are more prone to cyclical behavior; pursue growth opportunities that build on proprietary technology such as the design and management of wide area communication networks, this latter we see right now being terribly important in both China and Global Draw. And finally, incorporate maximum proprietary content in other intellectual property.

Sometimes adhering strictly to these principles seems to bog us down and limit our near-term growth, but in the long-term especially in times like these, the benefits far outweigh the drawbacks at least in our opinion.

Let me conclude by saying a few words about the upcoming second quarter and how we might think about it. I mentioned earlier that we were anticipating significant revenue growth from the first quarter to the second. The major drivers of this revenue growth include the expansion in the Global Draw installed base in the U.K. and Latin America, sales of instant tickets in China, the start-up of the seasonal contract and a return of license product revenues to a more steady state level. Each of these encompasses many or all of the strategic elements discussed a moment ago, and we can be confident therefore that this higher level of revenue growth is sustainable.

However, where the second quarter in particular is concerned, there are a few issues to be borne in mind. Because of the near term pressure of rolling out the China network to all the provinces, we are air freighting virtually all deliveries to China, and this along with value-added tax on imports into China is very seriously cutting into the profit margin on ticket sales although the validation system margin is of course unaffected. Hopefully, over the next few quarters, we can get ahead of demand and eliminate air freight and of course the tax will go away once we begin production in China. As we move beyond the second quarter and continue our rollout, we would expect to see expansion in both revenue and margins in China.

The seasonal contract as previously noted will run for the next 36 months and we expected to generate consistently good margins. But there are a lot of startup and other costs associated with the launch of what is essentially a custom terminal development procedure. And therefore, we do not expect the second quarter margins will be up to the average for the whole program.

Lastly, events taking place in the racing industry have sharply increased the fees we pay for the signals we show on our Connecticut off-track betting network. And at the same time, these same events are depressing industry handles, which in turn impacts the revenue of our racing systems business.

Notwithstanding the above, we are looking forward to a strong earnings increase from the first quarter to the second, and expect that the rate of increase would approximate the percentage increase we saw from the fourth quarter of 2007 to the first quarter of 2008, after adjusting the first quarter for the two unusual items identified earlier.

And with that we go now to Mike in Pennsylvania.

Michael R. Chambrello - President and Chief Operating Officer

Okay, thanks Lorne. While interest remains extremely high related to all of our China activities in progress, I wanted to start today's comments by focusing on the positive trends of our printed products and systems business before beginning to detail our really exciting China activities.

Many of you have expressed concern related to lower margins in our printed product business during second half of 2007. Lorne and I have consistently stated that this margin erosion was due to the ongoing integration activities of OGT, which we acquired early in the second half 2007. We had to define one-year integration plan, which we successfully concluded midway through the first quarter of this year. The results of this final integration can be seen in the strong margin improvement in printed products from Q4 '07 to Q1 of this year, 39% improving to 43%. As Lorne stated, we are now within about percentage point of our historical printed product margins one quarter ahead of our OGT acquisition plan.

We also saw some margin pressure in Q1, resulting from the launch of China instant tickets. Would all tickets been printed in the U.S. and exported to China, that margin is well below average in Q1 and as Lorne said, we'll see that probably for the balance of this year, but we will talk a little bit more about that momentarily.

As Lorne mentioned, we've taken a one-time charge of $2.8 million related to the restructuring of our phone card business in the U.K. This restructuring will result in a reduction of approximately 90 employees during the second quarter of this year and that process is in place and ongoing. The annualized cost savings resulting from this restructuring will exceed $3 million annually and, in fact, we anticipate that by the end of this year, we will have recouped the vast majority of one-time cash charge that we are taking in Q1, so we continue to adjust as necessary in that business.

We really haven't talked too much about Italy on recent calls, but we continue to be amazed at the ongoing growth of instant tickets in that market. One of the most interesting and really intriguing phenomena is consumer reaction to the introduction of new games particularly those at higher price points. Each new game introduction provides incremental sales with virtually no erosion in the sale of existing games, something that again is virtually unheard of in other markets worldwide.

Working with our consortium partners, we see significant and sustainable long-term growth well into the next decade. As the consortium continues to expand its player base, innovate and provide superior customer service to the Italian market. Also sales of scratch tickets continued to grow nicely in the U.K., in fact year-over-year growth from 2007 was 17%. That trend is continuing in expanding in 2008 and is reflected in our strong Q1 earnings.

As scratched tickets continue to be the primary engine of growth in the U.K. and remain a core component of Camelot growth strategy today and under their new license. Here in North America, same-store sales continue to demonstrate great resiliency in these uncertain economic times, growing at an adjusted rate of just about 9% in Q1. The timing of NDI revenues as Lorne mentioned in contract award continues to be a little difficult to predict. We saw some slippage of contracted business from Q1 to Q2, primarily related to the movement of some major league baseball games, as well as movement of "deal or no deal" related activities in Q2. The very good news on the MDI front is that this business currently... the business currently under contract for Q2 will likely result in almost double the revenue and profitability for Q2 versus Q1 of this year. While a bit difficult to predict quarter-over-quarter from a timing perspective, MDI and licensed products remain a key and core driver of our printed product business growth activities and excitement.

Moving onto systems, clearly, the biggest news related to systems is as Lorne mentioned; the announcement of Pennsylvania's intention to award the online contract to Scientific Games. As Lorne stated, we were here last week to kick off the negotiations with the PA lottery and while those negotiations are ongoing, I'm very confident that these discussions will be successfully concluded in a very short period of time.

As we stated in previous calls, Scientific Games will continue to aggressively pursue new systems business as long as there are an adequate return on our investment. It's clear that our revenue in Pennsylvania will be lower under the current agreement... than under the current agreement, however, it's worth noting that the cost savings related to the new satellite communications network, a relocation of the backup data center to our national data center in Georgia and significant cost reductions related to the ongoing maintenance and reliability of our new state-of-the-art wave terminal will result in an a appropriate return on our investment in Pennsylvania.

Now it's worth digressing just a minute here to discuss the new wave terminal. We undertook the development of the new terminal in January 2006. Our design process included extensive discussion and focus group testing with our worldwide customer base and probably most importantly, with real world retailers. We included the use of third party firms to help us with the design, ergonomics, and maintainability of the terminal. It's interesting to know that one of the firms that we used also designed the mouse for Apple, another piece of hardware that helped revolutionize a different industry.

Concept phase to field deployment took just over 18 months, really in my experience a pretty remarkable accomplishment. Today, we are very pleased to say we have over 2300 wave terminals operating in Connecticut and I think it's fair to say that the wave played a major role in PA's decision to award its online contract to Scientific Games. As Lorne mentioned, the rollout of the first 5000 terminals for Cecil [ph] will begin in Q2 with the balance of the 25,000 or so terminals being delivered over the next 36 months. Clearly, our investment in short time to market played a major role in adding significant value related to the terminal and new contracts just months after its introduction.

While we experienced lower systems product sales in Q1 versus last year and these were primarily related to the sale of instant ticket checkers in Canada in Q1 of last year, our overall margin continue to improve primarily due to our ongoing focus on improved operating efficiencies, with a moderate but a nice power ball role in Q1.

Finally, in those systems discussed and is complete without at least a mention of Mexico. We continue to work with Televisa to optimize the retailer network and I am happy to report this has resulted in pilot programs in a couple of large blue chip retail chains in Mexico City. We will be monitoring and discussing those test as we move forward and as previously discussed, we will be testing and re-launching the online product later this quarter and into next summer... into this summer, sorry.

We continue to believe that the long-term success of this program is relied upon the implementation of instant tickets slated for the second half of this year. Ironically, given the insizeable demand for instant tickets in China it's unlikely that we would be able to produce a meaningful number of tickets for Mexico before the end of this year anyway. So, the timing really isn't so bad.

Finally, let's move on to China. Having just returned from there last week, I can tell you first hand that the excitement surrounding the launch of instant tickets by the CSL is probably exceeded only by the excitement related to the upcoming Olympics in China in August and of course that you are very closely linked.

Let me start by simply trying to provide you some data that I believe you will find as incredible as we do. Approximate sales in China today exceed $180 million, despite starting off in only one province Shandong just six weeks ago. In those six short weeks, we've rolled out instant tickets in an additional eight provinces representing a population of approximately 500 million people, really numbers that are tough to get your head around. The project plan anticipates the rollout of all 31 provinces prior to the Olympics. I really do think this is a bit aggressive, but it further highlights the very strong demand for this product and how well it's been accepted in such a very short period of time.

If we were simply to take the current sales run rate in these nine provinces, annualize them, sales would be approximately $1.7 billion. This, despite the fact that less than 15% of the initial 90,000 terminals currently on order have been delivered, we anticipate 40,000 terminals give or take will be delivered by the time of the Olympics and I tell you that I now believe ultimately we'll double that number terminals, double the 90,000 terminals within the next 12 to 18 months. So a logical question is how we are going to meet ongoing demand. As Lorne described we've already ordered the second press for China almost three years ahead of our original plan. And will have a press up and operating in China by the fourth quarter of this year. And a second press similar to the one installed in Georgia last year, which will be operational in Q2 of 2001. Combined, these two presses will have the capability to produce over 12 billion standard tickets annually, something that we believe will meet demand for a period time, although we are certainly beginning to explore third press actions already.

In the meantime, we continue to maximize the production schedule on our Georgia facility and or ship tickets to China. While this method of transport significantly impacts our production margin as Lorne mentioned, this incredible volume feeds the revenue stream associated with our national systems contract. Overall, it's just a great deal and opportunity.

Like Italy, we believe that the long-term growth opportunity in China is significant and sustainable. We're already working with the China's sports lottery in the design of the next wave of post-Olympic instant ticket. Our focus group testing reinforces our belief that while the Olympic Games were a great vehicle to launch instant tickets in China, the product itself has widespread appeal across a multitude of games independent of the Olympics. The continued expansion into new provinces, our aggressive retailer and terminal expansion activity, coupled with higher price points provides the future for a significant and great long-term growth.

Many of you have asked about CSP or Cooperative Service Opportunities in the future. As you know, our first co-op contract is with Shandong province. Given the demands of the rollout, and frankly the pent-up demand for instant tickets during this startup phase, we don't intend to focus on CSP expansion until early next year. We continue to view CSP as a significant opportunity, but with the exception of Shandong, one that will be pursued more aggressively post-startup.

It's still too early, only six weeks to forecast sales for this year with a high degree of accuracy. However, it's safe to say that sales have greatly, even wildly exceeded expectations to-date. We expect dramatically higher run rate, annual run rate beginning in the second half of this year with the continued provincial and retailer expansion and significantly increased terminal density resulting in a dramatically higher run rate in sales. Not to be lost in the great success of the CSL launch is the steady growth and improvement related to Guard Libang, the company we acquired a 50% interest in during Q4 of last year.

Since this acquisition, Guard Libang has expanded from 13 to 23 jurisdictions and achieved profitability in Q4 of 2007. We expect continued growth in market share and profitability; it pays well ahead of our acquisition model with a positive and material EBITDA impact beginning in Q2 of this year. Like Lorne, I'm extremely bullish on our near term outlook with high expectations for Q2 of this year. With that, and I think it's pretty bright note, I would like to return the program to Lorne.

Michael R. Chambrello - President and Chief Operating Officer

Thanks, Mike. Operator, you can open up the program now for Q&A.

Question And Answer

Operator

[Operator Instructions]. And our first question comes from the line of Larry Klatzkin from Jefferies. Please proceed.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Hey guys, great quarter actually.

A. Lorne Weil - Chairman and Chief Executive Officer

Thanks Larry.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Quick question for Lorne, for you, what do you see is your involvement in 2009?

A. Lorne Weil - Chairman and Chief Executive Officer

My involvement in Scientific Games, I assume you mean?

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Yes, exactly.

A. Lorne Weil - Chairman and Chief Executive Officer

I don't see my involvement in 2009 or for that matter 2010 and 2011 being really materially different from what I spend most of my time doing now, you know most of my time is spent on you know business development, new business ideas, M&A, I spent a lot of time with customers and that's the stuff where I think I really add value and the stuff that I really way. And I don't really see that changing much. I think what will happen is I'll spend considerable less of my time on some of the other day-to-day kinds of things that Joe Wright will be picking up from me and which at least right now, Mike doesn't have any time to deal with because between China and all the other initiatives that he has going, he is working a 100 hours a week already, so I don't... I don't see any significant change other than to be honest having an opportunity to be more effective at the kinds of things that I really should be spending most of my time on because I will have... I will be devoting less of my time to the stuff that frankly I think Joe Wright will do a much better job at than I can do.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

That's good, I'm glad to hear that. Couple more information things; could you say how many for Games Media, how many units right now you have placed to may how many pubs?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, we either have placed or we have commitments right now to be placed, but may not have gone outdoor yet. It looks like around as many as 500 pubs, so that would be well in excess of 1000 machines.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Excellent, okay. And what is your rollout, do you think for the rest of this year, how much could you on the year by?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, you know our original plan for the year was to have between 5000 and 6000 machines rolled out by the end of the year. I think that certainly possible still from a customer commitment point of view that I think we're... I think our thinking is to try and go a little slower deliberately, so that we can focus more on maximizing the daily win of the machines that we have out in the field already rather than rushing to bring the installed base up too fast. And I think in the longer run, that's a better strategy.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Alright, and I don't disagree. As far as company-wide production capacity, when you have China done, am I calculating right, about 60 billion ticket capacity annually?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, that sounds just about right. Then I think immediately after that our next move will probably be to put a brand new state-of-the-art press up in Montreal. In Montreal, we're still operating with fairly old equipment that we inherited from OGT when we did the OGT deal, and we see a tremendous opportunity for us in the Canadian market, where we really haven't participated before. But in order to do that, we have to really significantly I think upgrade the capacity in Quebec, and so that would be our next move and that would then take us of course to something over 60 billion.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Alright, good. And then I read an article about VLT legislation in Italy. Is there any traction in that or is there we could be hopeful for?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, they've talked about VLT legislation in Italy several times in the past and the legislation that they've been working on for really the last several months and which was getting us to the point where we thought that this really was going to be a significant opportunity then there was a change in the Italian government. So, who knows if the new government is going to want to stay on course with the same program that the old government had. Certainly, if they sort this thing out politically, it's a terrific opportunity for us, because we have, as you know, some excellent relationships with major Italian operators and I would certainly expect that if in fact they do go ahead, and if they do, it plays very much into our hands, because the technical requirements are such that I'm not sure really anybody other than us are capable of meeting them.

It's a transactional system. It's server-based. It's all the things that we do pretty well. But again, because of the change in government, we're just going to have to wait and see how the politics sorts itself out.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

Alright. And then this outlook for Global Draw terminals outside the U.K., you have a 1500 being placed, still being put in, in Mexico. That's going to grow, and there is anything else going on?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, there are other operators in Mexico that we're talking to that we think will be very interested in our product as they get to understand how it works and as they get to see what the performance has been. And again, as we mentioned in the press release and we talked about before, there are a few other terrific opportunities in Latin America that I can't unfortunately be more specific geographically for reasons that I think you can probably appreciate.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

All right. And then one last housekeeping for DeWayne. Corporate was a little higher than usual. Should we use corporate, same number?

DeWayne E. Laird - Vice President and Chief Financial Officer

No, I think if you are including in that corporate number the stock-based compensation, that was up a little bit in the first quarter of this year comp like it was in the first quarter of last year. So, I don't... if I move back down in the second quarter of this year to more normal rate.

Lawrence A. Klatzkin - Jefferies & Company, Inc.

All right, thanks guys.

Operator

Our next question comes from the line of Celeste Brown with Morgan Stanley. Please proceed.

Celeste Mellet Brown - Morgan Stanley

Hi guys, good morning.

Michael R. Chambrello - President and Chief Operating Officer

Good morning.

Celeste Mellet Brown - Morgan Stanley

Just a few questions for you so we don't go too crazy with the revenues and not on the expenses so. In terms of... Lorne, you mentioned putting in a new system in Europe and further in two other countries for the Global Draw, what kind of cost will be associated with those?

A. Lorne Weil - Chairman and Chief Executive Officer

Probably about say between $5 million and $7 million per each of those, once they each reach their full number of terminals, which you know certainly won't be on day one.

Celeste Mellet Brown - Morgan Stanley

That's $5 million to $7 million of CapEx that can be depreciated?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes.

Celeste Mellet Brown - Morgan Stanley

Just in terms of sort of what we can expect in a sort of quarterly expenses?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes. I mean the models is pretty much the same as the model that we have in the U.K. We typically we spend $5,000 or $6,000 or $7,000 on the entire installation on a per machine basis and we look on a participation basis to get about that much revenue per year.

Celeste Mellet Brown - Morgan Stanley

Thanks. And then can you give us a break down of the units at the end of the quarter for the Global Draw? Were they mostly UK or how many Mexico machines are now?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, they are mostly U.K., we would have as of the end of the first quarter, we would have just a few hundred machines in Mexico, and about I guess 11,000 or more in the UK.

Celeste Mellet Brown - Morgan Stanley

Okay. And then what was the Global Draw EBITDA in the quarter? I know racing way down the unit?

A. Lorne Weil - Chairman and Chief Executive Officer

Excuse me one second. The... bear in mind that this number would include... will include the... if we exclude the earn-out charge, it's something over $12 million, closer to $13 million.

Celeste Mellet Brown - Morgan Stanley

And then in the second quarter, you finally will be so free of the re-pricing as you start to see better flow-through there?

A. Lorne Weil - Chairman and Chief Executive Officer

I'm sorry, Celeste, can you ask that question again?

Celeste Mellet Brown - Morgan Stanley

In the second quarter will be free of the re-pricing on your older contracts or we should start to see better flow-through from revenue to EBITDA on the Global Draw?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, although I think in the first quarter, again, if you exclude the earn-out charge, we saw already pretty good flow-through of the increased revenue into EBITDA. Yes, in the second quarter, it would be even better.

Celeste Mellet Brown - Morgan Stanley

Okay. And then --

A. Lorne Weil - Chairman and Chief Executive Officer

I think it's in the second quarter you'd have a full quarter's worth of the William Hill.

Celeste Mellet Brown - Morgan Stanley

And that's pretty, you've some nice cost benefits earned in terms of leveraging the system, right?

A. Lorne Weil - Chairman and Chief Executive Officer

Exactly, I mean virtually all the revenue of that we get from the William Hill should go in terms of EBITDA, straight to the bottom line. On the P&L point of view, obviously there is depreciation on the machines, but I don't think there is really any incremental cost.

Celeste Mellet Brown - Morgan Stanley

Okay. And then in Pennsylvania, are you carrying amortization right now associated with that original contract purchase or any depreciation?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, that's actually a very good question, because this is a very important aspect of the Pennsylvania situation. We actually have two components of D&A where the current Pennsylvania contract is concerned. There is the D&A on the actual capital equipment that we took over from IGT when we made the IGT acquisition. But in addition, when we bought IGT, we paid considerably more than the then book value. So, there was a substantial amount of purchase price that we have to amortize in addition to depreciation and we allocate that amortization proportional to the EBITDA of the contracts in Pennsylvania was you know by far our largest contracts. So, by far, the largest part of that amortization was charged to Pennsylvania, and that amortization will end when this contract ends at the end of or approximately at the end of 2008.

So, of course we have the new capital investment, but the depreciation on the new capital will be almost exactly what the depreciation was on the capital that we took over from IGT. So, the net result is that several million dollars of amortization that used to be charged against the old contract will not be there any more. So if I pick that up with the point that Mike was making before, which is we have significant cash operating costs reductions in Pennsylvania because of communications, the fact that the wave terminal is infinitely more reliable than the terminal that we inherited from IGT and so forth that we add to that the disappearing of the acquisition amortization, we can take a fairly healthy reduction in revenue in Pennsylvania and still wind up with a very good contract.

Celeste Mellet Brown - Morgan Stanley

It sounds like your old D&A for Pennsylvania is like $12 million to $15 million, your new D&A will be closer to $12 million, is that alright?

A. Lorne Weil - Chairman and Chief Executive Officer

No, no, no, no, the new D&A would be closer to about 6.

Celeste Mellet Brown - Morgan Stanley

6, okay. And am I high on the old one being 12?

A. Lorne Weil - Chairman and Chief Executive Officer

The 12 is pretty close, but the 15 might be little high, but the 12 is about right.

Celeste Mellet Brown - Morgan Stanley

Okay. And then... sorry for so many questions. In the equity income line, was the increase mostly Italy? Are you also booking a foreign exchange benefit there?

A. Lorne Weil - Chairman and Chief Executive Officer

DeWayne do you want to comment on that?

DeWayne E. Laird - Vice President and Chief Financial Officer

Yes, the increase was mostly Italy, and we of course you know, it does include the European... the euro being translated into U.S. dollar, so yes, they would have been a small increase there from the conversion.

Celeste Mellet Brown - Morgan Stanley

So you should, you should see that flow through, I think Automatica reported a 15% increase in sales. That should flow right through that line, plus the whatever conversion?

DeWayne E. Laird - Vice President and Chief Financial Officer

Yes.

Celeste Mellet Brown - Morgan Stanley

Okay. And then just a question for Mike, where is China run rating right now in terms of retail sales?

Michael R. Chambrello - President and Chief Operating Officer

If we again, we took sort of last week sales, two weeks ago maybe at this point, with just I say nine provinces, but that run rate probably included only eight provinces. We're at about as I said about $1.7billion. But I expect a fast acceleration with that when we get more of the infrastructure in place and certainly the goal of getting all 31 up and operating by the Olympics, but again I want to repeat I think that's aggressive, obviously it can, and will be significantly higher than that.

Celeste Mellet Brown - Morgan Stanley

So on a daily basis, so is about $4.5 million to $5 million of retail sales?

Michael R. Chambrello - President and Chief Operating Officer

Yes, but it's growing, but, yes.

Celeste Mellet Brown - Morgan Stanley

Okay, yeah, of course. And then just finally, how much retail sales, or what was the flow-through to games in terms of sales in China in the first quarter, on consolidated printing?

Michael R. Chambrello - President and Chief Operating Officer

For China in printing, as we've said, most of that, as we didn't start up until the very last week of March, very little of that revenue flowed through in Q1.

A. Lorne Weil - Chairman and Chief Executive Officer

And DeWayne is saying less than $1 million.

Celeste Mellet Brown - Morgan Stanley

Of flowing through to your retail sales, or your reported revenue?

A. Lorne Weil - Chairman and Chief Executive Officer

Less than $1 million of China revenue in our first quarter.

Celeste Mellet Brown - Morgan Stanley

And that's across online and instant?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes

Celeste Mellet Brown - Morgan Stanley

Okay. Thank you so much.

A. Lorne Weil - Chairman and Chief Executive Officer

Yes

Operator

Our next question comes from the line of Ralph Schackart, William Blair. Please proceed

Ralph Schackart - William Blair & Company

Good morning. First one is for Mike. Mike, I am just curious on China. Sounds like you've got a great growth trajectory, and you have got a lot of scale there. When do you think the margin structure as it relates to just China and scale to a point where it's going to match your consolidated instant ticket services results right now?

Michael R. Chambrello - President and Chief Operating Officer

Well, as Lorne stated, and I think I followed up on, when we start printing in China, there's not going to be a huge learning curve because the presses that were coming up were the presses that we are familiar with. So, I certainly would anticipate once we're fully operational printing in China in the first quarter, in this first half of next year, that it won't take us very long at all to get up to our historical average.

Ralph Schackart - William Blair & Company

Great. And Then Lorne, while we got you on for a few more calls, I was just wondering, obviously as you noted, it's kind of tough on the sell side to get all this right on a quarterly basis on our excel models, but can you sort of outline the growth trajectory in the instant ticket business, domestically and internationally from sort of 2008 and beyond at a high level for us. I think that would be helpful. Also then outlook can you walk us through Global Draw, it seems like all the pieces that you have been orchestrating are starting to come together. Help us think about growth in that business or how big it can be both at a top line and then the scale you would get at the EBITDA line?

A. Lorne Weil - Chairman and Chief Executive Officer

Sure. Let me take those one at a time. I think as far as the... actually interesting. I was in Boston a few weeks ago visiting, speaking to some investors, and I spoke to one guy who is with a major investment firm and they had commissioned one of the really best consulting firms in the country to do the most comprehensive piece of research and analysis I have actually ever seen done on the North American instant ticket business, much, much more comprehensive than anything we've ever done. They had a research and sort of the kind of metric methodologies that were 10 times more sophisticated than ours are, I won't bother trying to walk you through what their methodology was, but it was very sound and I spent a lot of time making sure I understood and at the end of the day agreed with it. And they have made a very, very strong case and bear in mind this was not done by somebody who is advocating on behalf of the instant ticket business, this was done by someone who is higher to as objectively as possible to try to sort out the issues and come to some conclusion about the... about where the business was going.

And the data and the analysis seemed quite unequivocal in projecting at least for the next four to five years great growth in the middle of upper single-digits. So, something in the 7%, 8% a year range and that was interesting, because as I think you know I had been saying lately that my gut sense of it is that's about what the organic rate in North America is too. So, if you want to integrate or synthesize my gut and this person who unfortunately I, for reasons I'm sure you can appreciate, I can't possibly identify... very, very solid research. I think that's where we can use as a point of departure of taking about the States.

The international market is a different kind of thing, that's more in the nature of what I was talking about earlier. There are still some potentially phenomenal growth opportunities. Mexico, of course is one that everybody is sick of hearing us talk about and I don't blame them, I'm sick of hearing it about myself. But, we see what's going on now in China at some point something like that will happen in India, at some point I'm sure something like that will happen in Russia. At some point something like that will happen in Brazil. It's interesting that of the so-called BRIC countries China is the only one that's even doing instant tickets, but as Mike was talking about before now that they've started it's going off literally like a rocket.

So, I think you have to take it country-by-country and model each of those out and then try and see what the envelope of that looks like. But, certainly if I take all the business as it exists right now, taking into account the growth that we're seeing in the U.K. and the growth that we're seeing in Italy, that there's going to be an acceleration of growth in France. It's a market that hasn't been growing in the last few years, but that is going to change. China, we can't even comprehend how big that's going to get. It certainly has to be the case that the market outside of the United States has be to be growing at a rate far, far in excess of the market in the States. That might be 2 or 3 times the growth rate of the U.S. and again it's just a question of the timing of some of these areas. I mean, I wish I could help you more and be more specific, but I think the lesson of history here is that these things all happen eventually, but the timing is just difficult to predict, but I can't fathom that if the U.S. growth rate is 7% or 8% that the international growth rate is in at least 15% to 20% if not more.

And by the way, I should say on that point it's why I'm puzzled when I read some of the research stuff, there was something that I saw this morning. Again, I won't mention any names, but a good solid thorough researcher talking... especially concerns that GTECH's participation in the instant ticket business was going to wreak havoc with profit margins, when this is really all a game of supply and demand and the rate of growth on the worldwide market is such right now that the annual growth is significantly greater than the entire capacity that GTECH will have when they finish installing their new press in Florida.

So, I'm sure GTECH will do fine in the instant ticket business frankly, I wish them well, but may be I was a student economics for too long, but if you look at this macro economic data, it's baffling to see how somebody can come to some of the conclusions with people who have been coming to.

Now, as far as Global Draw is concerned, you know we have huge expectations for this business. We went into 2007 at an EBITDA level of Global Draw of around roughly $30 million and we talked a minute ago, we are right now at a run rate that's pushing $50 million and I would expect that we will come out of this year at a run rate, EBITDA run rate something close to $80 million a year. And there are again, it's the same whole lumpy thing, but there Larry Klatzkin talked a minute ago about Italy, yes, and it's a big capital I, capital F, if Italy were to happen then that could be a market for us, it has the potential to generate annually EBITDA again in the tens of millions.

So, I would say that certainly our expectation is if we were to come out of this year, had in Global Draw at an EBITDA run rate of $80 million, then I would expect that going forward over four or five years from near that a growth rate of that least 15% to 20% a year, not more and the Global Draw portion is something that we would certainly be setting out an objective for ourselves and hoping that we can reach and then we'd have to add to that the sister company of our opportunity in games and media and as I mentioned to Larry Klatzkin before, I think something in the neighborhood of 5,000 machines is achievable by the end of this year. I would certainly expect that we could have something close to 10,000 machines by the end of '09. And that follows roughly the same business model of the Global Draw. We get around $5,000 or $6,000 a year in revenue per machine it runs off the same Global Draw networks, so there is virtually no incremental communications expense. It uses the Global Draw field operations organizations, we obviously will have to add some people if we are going to maintain another 6, or 7, or 8, or 10,000 machines. But, it's not a huge number in terms of cost. So, you can do the math and see how much that add so, I think if we were looking you know three or four or five years into the future, I think that's probably about the best kind of guidance I can give you in terms of the instant ticket business and the Global Draw business.

Ralph Schackart - William Blair & Company

Really helpful. Thanks, Lorne.

A. Lorne Weil - Chairman and Chief Executive Officer

Sure.

Operator

And next question comes from the line of Steve Kent with Goldman Sachs. Please proceed.

Steven Kent - Goldman Sachs

Good morning. Two questions; first, could you just give us a little bit more color on your domestic same-store sales expectations for instant ticket? I can't help, but notice that in the fourth quarter you are essentially negative and in this quarter it sounds like you are at 8% and 9%, so I wanted to understand how that either calculated or what you are seeing especially in line with the Oberthur results, which look like they are getting weaker as we get through in this quarter. And then separately, just on the Florida instant ticket contract, when do you expect to hear from them and where is your confidence level on winning that?

A. Lorne Weil - Chairman and Chief Executive Officer

On Florida, I let Mike answer again. On Florida, I prefer to say nothing but, except to say that we're cautiously optimistic that we'll be okay in Florida. I mean, they have been publicly releasing evaluation data over the course of the last several weeks, because it's been a public evaluation forum, and the data is made to the public. And as of the conclusion or completion of the publicly shown, demonstrated evaluation, we were considerably ahead. So on that basis, we would feel pretty good about this, but again, that's really all we can say right now.

As far as your other question, I'm not sure I follow the point about the deterioration in the Oberthur results. Maybe can you, if you can elaborate on what you mean by that, Steve, may be I can be responsive to it?

Steven Kent - Goldman Sachs

I thought it was like around may be 27 in the fourth quarter and low 20s in this quarter?

A. Lorne Weil - Chairman and Chief Executive Officer

20s, 20 what?

Steven Kent - Goldman Sachs

The top line of the income statement on the revenue side?

A. Lorne Weil - Chairman and Chief Executive Officer

I don't even know that that we even at this point we track the Oberthur revenue. It's not now that it's completely integrated, the former Oberthur business is are the plants in Montreal and Australia, and the former Oberthur customers are essentially served there and, put the foot predominantly out of El Phorata [ph]?

Steven Kent - Goldman Sachs

I mean it says in your release, excluding revenues from Oberthur Gaming Technologies of $19.50 million. I guess I am trying to track that?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, I'll have to sit down and examine that maps Steve, I don't --.

Steven Kent - Goldman Sachs

You know what? Then let's just talk generally about same-store sales and instant ticket. I mean I can't help but read, I actually don't know if you have Tennessee, but there's a little article today saying they're seeing weakness there. I can't help, but seeing that convenience stores are reporting weak results, so the 9% seems or the expectation that would sustain into the balance of this year seems aggressive to me and I just wanted to know what gives you the confidence that that would be, in fact, what the number turns out to be?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes, I don't know that it will be 9% for the year, but I'm fairly confident that it'll be between 5% and 10% for the year. Part of the problem in this whole same-store analysis thing Steve is that our... remember, what we're reporting is our sales to lotteries and what the lotteries are reporting when you talk to them or you look at their data is their retail sales and obviously, there is a time lag between A and B and there is constantly inventory adjustments. At the end of the year last year, our sales were weak or relatively weak and it had more to do with lotteries working inventories down than it did what the actual lotteries sales are. And I'm sure that we may be seeing in the first quarter to some extent a rebuilding of the inventory. So, our numbers jump around from quarter-to-quarter because we don't correlate directly quarter-to-quarter with what the retail sales of the lotteries are.

Certainly some of the lotteries like Tennessee are talking about their sales being softer and other lotteries like Pennsylvania, have talked about recently suddenly seeing a pickup in their sales. So, it's a mix bag, it is a bad environment. I mean the price of gas is $4 a gallon and unemployment is a bit rising and there is housing issues and all this stuff, but the question the gentleman asked before is over the course of 4 or 5 years. Hopefully, over the next 4 or 5 years, we won't have 5 years worth of the kind of economy we have now, but probably we have it for however longer sessions last and then things will improve. And if we make the assumptions that one year out of five stinks and four years out of five were good in the external environment, then I'm absolutely confident that over that period of time the instant ticket growth rate is going to be in the upper single-digit, but is it going to be that every single quarter and in particular every quarter of this year, I don't know and I am not sure I care.

Steven Kent - Goldman Sachs

Thanks.

Operator

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

Robert J. Evans - Craig-Hallum Capital Group

Good morning every one, and nice progress on the quarter.

A. Lorne Weil - Chairman and Chief Executive Officer

Thanks, Bob.

Robert J. Evans - Craig-Hallum Capital Group

Can you comment first on Italy, the... you had a very strong quarter. Should we be thinking about that in terms of a run rate how should be think about that kind a going into Q2 and the balance of the year?

A. Lorne Weil - Chairman and Chief Executive Officer

Mike, do you want to talk about that?

Michael R. Chambrello - President and Chief Operating Officer

Yes. You know, one of the great things about Italy is again every time a new game is introduced, particularly at the higher price point, the €10 price point in particular, we are seeing it is incremental. At some point, you sort to get the sense that it has to slowdown a little bit, but we are pretty confident that will save... will track in Q2, Q3, Q4 et cetera at growth rates that mirror the trend from last year obviously the summer season particularly in Europe is slower. But if you take the 15% and sort of trend it out over the year-over-year, we remain very, very bullish on it. And, again there is something even with Italy for us keeping in mind that we sell into the consortiums, so at times there are inventory-related and timing-related issues. But now we are very, very bullish and we think Q1 was indicative of what we are going to see for the year and well into the future.

Robert J. Evans - Craig-Hallum Capital Group

Okay. You guys if we look at your year-over-year, we have perfect data, but it looks like your profitability might be at merely 25% on the other income line. Is that the right way to look at it or are we being a little bit aggressive there?

Michael R. Chambrello - President and Chief Operating Officer

I don't have that. DeWayne, is that what we have or you have?

DeWayne E. Laird - Vice President and Chief Financial Officer

I am sorry, Bob.

Robert J. Evans - Craig-Hallum Capital Group

You know what, I'll go through that with you offline, it's not a... we can have a discussion another time. Then back on Italy, just if you could clarify something, because there has been chatter out there in terms of kind of your relationship with Lotto America and how that might look long-term? Can you talk to that if you will, Mike, in terms of how we should do that?

Michael R. Chambrello - President and Chief Operating Officer

Yes. Well, I think you should look at the consortium that's in place today, as the consortium that's going to be in place for very long time. Lorne mentioned earlier that the new government is organizing so, we are not sure how and when the timing of the new license period but, I say with great confidence, the consortium has been huge success, works very, very well together, it's highly complimentary, provides the strongest group and team that could ever support that expanding Italian market and we're obviously thrilled to be part of the consortium and anticipate and expect to be the part of consortium for many, many years to come.

Robert J. Evans - Craig-Hallum Capital Group

Okay. So, the feedback you are getting by everybody is that things will stay as is.

Michael R. Chambrello - President and Chief Operating Officer

Yes, I don't see any reason why anyone would want to change this formula for success and we've got just a tremendous working relationship with everyone at Lotto America, tremendous.

Robert J. Evans - Craig-Hallum Capital Group

Okay. Okay, thanks. And then on... in China, can you... I may have missed this. But how many retailers are you in now and by the time the Olympics roll out or Olympics are there how many ballpark would you expect to be in?

Michael R. Chambrello - President and Chief Operating Officer

Well, you know, that's a very, very difficult question to answer because keep in mind that model that we are using in China, which by the way, is a model that we've really, really come to like in some of the large international opportunities that Lorne mentioned earlier form Russia to India to Brazil and others. It's a model that we really see working very, very well. And that's not to have the traditional discreet terminal and landline with the associating communications clause for every retailer, but to have a simple handheld device, think of it in terms of like a rental car device with a reader on it and so, in China you can think in terms of every one of those handheld devices probably serves somewhere to 5 to 10 retailers in some places more, remember they've got a lot of street vendors and things of that nature. So, if you were to look at having 90,000 terminals in place, you could double, triple, quadruple that number into a very comfortable that you probably are still being slightly conservative with the total retailer base. Is that --?.

Robert J. Evans - Craig-Hallum Capital Group

No, no, that's helpful. And Lorne, or may be whoever, on the CSL [ph] contract that I think you said starts to hit in Q2. Could you give us some sense of revenue magnitude for that?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, we've talked before about the whole program being 25,000 terminals and in the kind of $90 million to $100 million revenue range and we are going to ship them more or less evenly over the 36-month period. So, again it's just a question of going through that map of --.

Robert J. Evans - Craig-Hallum Capital Group

Okay, okay fair enough. MDI, could you give us a ballpark number of how big it was in Q1, I know seasonally speaking was kind of down but --?

A. Lorne Weil - Chairman and Chief Executive Officer

Yes ballpark figure MDI in Q1 was $10 million-ish in revenue and as Mike said, it should come back to at least $20 million in the second quarter, which is really where it should be, but the $10 million in the first quarter is a normally rather than the higher number of 20. The 20 is, if you look ahead over the next, certainly three or four or five quarters, the 20 or more is... that's the level where those sales should be.

Robert J. Evans - Craig-Hallum Capital Group

Okay, okay. And can you give any help or granularity as it relates to... I know Q2 is going to be a record quarter and I think you said it grew significantly over the last year. I am trying to get a greater sense of significantly and so we're not too far ahead of ourselves?

A. Lorne Weil - Chairman and Chief Executive Officer

Well, I think I said in my presentation earlier, if I wasn't clear, let me clarify a little bit. I think that the sequential, if you are talking about EPS, and again, you know we don't give guidance and this could be plus or minus, a few cents either way. But directionally, right now, we would see that the EPS in the second quarter would be as percentage wise as much over the $0.24 of the first quarter, if we use that $0.24 as the let's call, the adjusted EPS as the first quarter was over the fourth quarter.

Robert J. Evans - Craig-Hallum Capital Group

And you are using what in the fourth quarter, 17 or --?

A. Lorne Weil - Chairman and Chief Executive Officer

17, yes.

Robert J. Evans - Craig-Hallum Capital Group

Okay. And then, okay. And then from a revenue... how should we think about the revenue granular. Can you give a brief?

A. Lorne Weil - Chairman and Chief Executive Officer

Let's put it this way. I mean, again if you take what we are saying before in terms of it being significantly higher than the first quarter and significantly higher than the second quarter last year. Then it's certainly within the realm of logic and feasibility that it's a number that could start with a three.

Unidentified Analyst

Okay, fair enough. Thank you very much. Look forward to Q2.

A. Lorne Weil - Chairman and Chief Executive Officer

Good. Well, I guess that's it for questions. Thanks everybody and I think we really are now at about the most exciting turning point that I can recall in the many years of being involved with this organization. And I am hopeful that in the two or three remaining conference calls that I have that we will actually get to the point we've been looking to get to. And I think we're, I think we are absolutely on that track not withstanding all the vagaries in the environment and so forth. So, thanks again and we will talk to you in another quarter.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Everyone have a great day.

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