Description

Scientific Games common stock (SGMS) at its current price of $11.46 offers investors a compelling opportunity to purchase reliable, protected and growing cash flows at a material discount to its competitors’ valuations.  In October, 2013 SGMS supplemented its lottery based model when it purchased the complimentary products and services of slot-machine manufacturer Williams Industries (WMS).  However, since the acquisition, SGMS’ stock price has suffered from various negative perceptions; including:

• A historically poor management team whose inconsistent growth strategy resulted in a materially underperforming stock over the last 5 years
• Exposure to the saturated regional gaming market and SGMS’ guilt by association with IGT’s recent dismal operating performance selling slot machines (IGT’s revenue declines were in fact exacerbated by SGMS’ capture of IGT’s market share)
• A material shareholder base of long/short equity hedge funds that have suffered from the recent “high beta” stock sell-off, forcing them to sell under-performing holdings and perpetuate the self-fulfilling negative price cycle whereby when they sell SGMS it forces others to sell SGMS which in turn forces them to sell and so on
• A woefully ineffective IR effort that failed to articulate the obvious and attainable synergies that would accrue from the SGMS/WMS merger
• Limited and confusing sell-side coverage that includes only 3 brokers; one of which (Deutsche Bank) published a “sell” rating, replaced the analyst with another analyst who has yet to update the stale rating

Despite these perception overhangs, SGMS possesses the classic “tells” that typically indicate a high reward/ low risk investment, including;

• A recent significant corporate action where SGMS acquired Williams Industries in order to reap very attainable financial synergies (primarily cost savings but with upside optionality on revenue synergies) using low cost debt
• Management change where the prior SGMS CEO, CFO and IR officer were all replaced in the last 6 months by well-respected executives (new CEO David Kennedy was the CEO of Revlon and a SGMS board member for 4 years, CFO Scott Schweinfurth was the former new CFO of WMS and Bally’s (BYI) and new IR officer Bill Pfund was the lead IR at WMS)
• An asset base (both SGMS and WMS) with a long history of robust cash flow generation and a current FY14/15 valuation materially below its peers in terms of EBITDA multiples and FCF yields
• WMS most recent slot models (Blade and Gamefield XD) generate 1.3x average house daily win averages and are taking market share from IGT slot products
• Significant recent share repurchases in the last quarter ($29.5mm at $14.75/share) with an additional $75mm approved
• Ron Perleman owns 38% of the common stock and is chairman of the company (Perleman is worth $14bln and has a history of successful investments) 

We believe SGMS is the sum of three distinct and valuable cash flows: 1) a lottery business characterized by high margin, long duration and very reliable cash flows, 2) a gaming business that despite its exposure to the cyclical slots industry has a history of producing popular game content that drives above average daily wins per machine and 3) very tangible cost and revenue synergies between the lottery and gaming business that should eliminate material redundant expenses as well as capitalize on the obvious revenue cross-selling opportunities between lottery and gaming customers. 

We think SGMS generates $193M of free cash flow in FY15 which at its current price produces a 20% free cash flow yield.  At a 10% yield, the stock should trade at ~$23/share, a 100% gain from today’s price.

Description of the New SGMS Business Segments:

Post the Williams acquisition, SGMS’s business lines are divided into two major groups: Lottery and Gaming.

Lottery Segment

The Lottery business line includes printed products, systems, gaming/interactive (this has since moved to Gaming but the legacy SGMS business requires some explanation) and equity investments.

Lottery Instant Products

The primary lottery product created by SGMS is the ubiquitous “scratch and win” lottery ticket for instant games (the customer removes scratch-off coating to know immediately if they have the winning combination).

Although humble in size, the instant lottery ticket is a complicated product and requires a skilled set of services.  SGMS supplies 40 (out of a total of 44) different instant lotteries in the US and over 50 different instant lotteries internationally.  SGMS operates 5 instant lottery game printing facilities around the world which collectively manufacture 44 billion instant tickets annually and has capacity to meet expanding demand for several years.  This service is a bit similar to actual sovereign currency mints in that SGMS must safely and securely deliver these tickets to thousands of retail outlets around the world without jeopardizing the quality and integrity of each lottery.  There is a significant risk that the tickets are manipulated to favor one party or that the tickets accidentally over-allocate instant lottery pots to multiple winners.  This is not a service that a vendor wins on solely price.  It requires a sophisticated, secure process with a long history of successful execution.  Typically, SGMS is one of only three instant game lottery providers worldwide that has the experience and the ability to win these contracts.

Lottery Systems

Draw lotteries use POS terminals at retail outlets to distribute tickets to customers.  SGMS provides the POS terminals, the networks linking the terminals to a central database as well as the central database itself. These systems process in real-time the wagers of both the draw lotteries and instant lotteries as well as validate the winning tickets.  In addition, SGMS operates an extensive field staff of technicians that support and maintain the individual components of the lottery value chain (POS machines come in several different forms, including the traditional retail machine at a convenience store, a self-serving vending machine as well as an online site).

SGMS also adds value to the marketing and business development of the individual lotteries.  SGMS operates a significant portion of their lottery business on a participation basis (their revenue is tied to a % of total lottery revenue) in which they are responsible for necessary cap ex (in Italy they supply the POS systems to the Italian Tobacconists Federation) as well as marketing (they license brands like Monopoly for instant ticket faces) and business development (they work with large retailers to increase penetration of non-traditional vending platforms like gas-pump machines).

Legacy SGMS Gaming/Interactive

The legacy SGMS gaming business manufactured and distributed slot machines (with both software and multi-title content) to betting shops (Ladbrokes), bingo halls and arcades in the UK and the Caribbean/Latin America.  The installed base is ~30k participation machines (with 24k in the UK).  These boxes do not have all of the “bells and whistles” of typical Las Vegas slot machines but they provide multiple game content that attracts the high frequency players, particularly in the UK.  SGMS also manufactured and distributed VLTs (Video lottery terminals) which are simply slot machines monitored by a public jurisdiction (as opposed to a private operator).  Both of these business lines have moved into the gaming business segment which now includes the Williams slots as well.  Although these games sell for lower ASPs than Williams’ Blade or Gamefield xD machines, they generate gross margins comparable to the Blade models.

SGMS legacy interactive business primarily revolved around their online platform to sell instant and draw lottery tickets.  As states move to capture more of the gaming revenues within their respective states, they will offer their own online gaming sites in lieu of or in competition with private sites.  In Delaware currently, the state offers an online gaming portal for Delaware residents that uses SGMS technology and content to operate online casino games.   This presents material growth opportunities to monetize WMS vast library of gaming content on state controlled online gaming portals.  This business line has moved into the gaming business segment post the WMS acquisition.

Equity Investments

SGMS historically has invested in joint ventures or consortiums of lottery/game providers.  These investments ranged from the very logical to the very confusing but overall reduced the transparency and predictability of SGMS financials.  Prior to the acquisition, SGMS management never provided financial guidance and consistently bought and sold equity stakes in companies that obfuscated the underlying health of the core SGMS lottery business.   The majority of SGMS’s current equity investments now follow a consistent logic and management has shown an understanding to clean up the less consistent investments (it sold its 20% equity interest Sportech, a UK online wagering company in January 2014).

The typical SGMS equity investment is a minority stake in a consortium of lottery product & service providers that attempts to buy the rights to run a government lottery.  Governments around the world have moved toward outsourcing and privatizing former government functions, including lotteries.  SGMS owns 20-50% stakes in JVs that currently operate the state lotteries in Illinois, New Jersey and the national/regional lotteries in Italy, Greece and China.  In all cases, SGMS is selected by the consortium to be the ticket and systems providers to the respective lottery.  In addition, SGMS collects its share of the consortium’s annual income.  Over the last 4 years, SGMS has generated on average ~$83mm in annual EBITDA from these JV investments, which is separate from the operating profits they make selling their products and services to the lotteries.  Management has also stated that its current JV investments will not require any material additional equity investments so that they should be able to hold current JV annual EBITDA contributions steady without any significant deductions for equity infusions (basically another form of cap ex).  Any new equity investments will require an initial upfront capital payment and management has clearly stated that they target positive NPV returns on all of these investments.

Historical Legacy SGMS Financials

Historically, the lottery printed products and systems sales have grown at low single digits with some lumpy years where SGMS adds or subtracts a customer.  However, given the typical lottery contracts have 3-5 year initial terms with multiple renewal options for up to an additional 5 years the revenue stream is fairly predictable.  SMGS’ legacy gaming systems sales are much more volatile over time.  Between 2011 and 2013, SGMS gained and lost several contracts in the UK for their VLT machines.

Adjusted EBITDA margins for the lottery segments have remained constant over time reflecting the stickiness of that business.  Gaming, on the other hand, generates lower and more volatile EBITDA margins, reflecting the more “hit” oriented nature of slots in which manufacturers must predict which game will achieve higher popularity among users. 

Gaming Segment

The “new” gaming business line combines the gaming assets of WMS with the legacy gaming segment of SGMS (primarily the manufacturing and sale of VLTs) as well as the non-lottery legacy interactive segment of SGMS (their operations online gaming sites for commercial customers).

Slot Machines – Industry Background

SGMS acquired WMS in October 2013 and combined its operations under the Gaming segment. WMS is a leading provider of casino slot machines, video lottery terminals (VLTs) and online gaming.  The gaming industry is large with over 1,500 casinos across North America with an installed base of 940,000 gaming machines.  The gaming machine industry is mature and highly competitive with multiple suppliers.  The market leader in the space is IGT with ~40% US slot share while Bally, Aristocrat and SGMS/WMS have 10-15% each.  Casino operators continually seek to improve profitability per square foot and typically deploy a balanced mixed of low, mid and high-end machines to cater to wide spectrum of customers.  High-end machines have newer content, larger screens, slimmer profiles (requires less real estate) and are more easily serviceable.  Generally, game content and design is a key differentiator among machine suppliers because it leads to increased customer interaction and ultimately higher spend.  Operators measure performance by recording a machine’s average net win per day and manage these assets on a portfolio level, upgrading or replacing underperforming machines while balancing diversity.  There are two prevailing business models: product sales and participation (aka GameOps) revenue.  Operators can either outright purchase game machines or lease them, paying manufacturers a lease fee and a portion of customer spend. 

Gaming Products

The segment is divided into two sub-segments, Products and Services. 

• Product sales include the sale of slot machines to operators, VLTs and conversion kits.  WMS sells a range of product lines from lower-end cabinets such as BlueBird (2006) and BlueBird 2 (2008) to next-generation Blade (2013) cabinets.  Blade cabinets have newer content, larger high-resolution screens and slimmer profiles compared to older models.  Typical customers of Blade are generally those who demand high-end cabinets that drive higher spend/day.  Casino operators looking to upgrade their portfolio of slot machines with the latest content would select cabinets such as Blade.  BlueBird cabinets are lower-priced and are mature in the product lifecycle.  They can be used as video-lottery terminals (VLTs) where the price point is attractive.  For example, in Illinois, local taverns would purchase BlueBird machines for their patrons.  Gross margins between Blade and BlueBird are similar given that Blade cabinets are ramping up in production and still have margin expansion efficiencies while BlueBird cabinets are mature and have reached maximum margin potential.
• Services revenue is generated from casino slot machines that fall under participation contracts, maintenance agreements and interactive revenues.  Participation contracts are commonly known as Game Operations or GameOps in the industry.
  • Casino slot machines that fall under participation contracts are generally based on a revenue sharing model such as % of net win or % of coin-in plus lease fees.  The gaming machines under services revenue are generally higher-quality with licensed content and command more floor space than those sold under product sales.  Manufacturers such as WMS generate better economics under these participation contracts while casino operators avoid paying substantial upfront costs to acquire these games and risks of owning machines that may decrease in performance over time. 
  • Interactive revenues relate to online gaming apps and online real-money gaming.  For online gaming apps, WMS generates revenue from in-app purchases through platforms such as Apple, Android and Facebook.  For online real-money gaming, WMS provides its slot content to legal online casino operators (primarily in Europe and launching in New Jersey).

Historical Legacy WMS (“Gaming”) Financials

WMS hit a strong product cycle with the launch of BlueBird in 2006 and BlueBird 2 in 2008.  At that time, those products were considered high-end with very attractive content.  WMS’s revenue grew double-digits in the first several years of this new product cycle.  Gross margins for product sales were typically 50% while participation and lease revenues were 80%. 

However, the company failed to release a follow-up hit product and completely missed a new cycle, causing its BlueBird cabinets to run stale and demand to fall.  Revenues and profitability dropped in calendar year 2011 and 2012.  WMS refocused and spent much effort on developing its Blade and Gamefield xD cabinets.  Through the extended development cycle, financial performance continued to decline along with its share price. 

In early 2013, WMS had an inflection point in revenue growth due to its new product releases: Blade (WMS’ premier premium game cabinet) and Gamefield XD (WMS premier next generation participation game cabinet).    Although product sales declined in 2013 overall, this was primarily due to a large one-time Canadian VLT order in 2012 that made the sales comps difficult.  If one nets out the 2012 VLT order, WMS Blade cabinets displayed strong demand in 2013.  Excluding this contract, y/y unit growth was -2% while ASPs grew +1%. 

Likewise, participation revenues have grown due to the release of Gamefield xD.   In Q4’13 WMS actually grew its participation revenue 4% with gains from its new Gamefield xD, surprising the market and significantly exceeded IGT’s participation Q4’13 revenue growth of -8%.    

SGMS Acquisition of WMS Industries – Background

On January 31, 2013, SGMS announced the acquisition of WMS Industries for $26/share or $1.5bn, which translated into a 6.3x 2012 EBITDA acquisition multiple or 4.5x when accounted for the proposed $100M in cost savings they hope to achieve by Q4’15.  WMS provided significant strategic value and synergies for SGMS.

Overall Strategic Rationale

From a high level, SGMS management pursued this acquisition due to industry shifts that are occurring.  Government entities are continually looking to increase revenues and are focusing on growing their lotteries, which ultimately compete for the same wallet as casino operators.  Lotteries are beginning to launch online lottery ticket purchases as well as launch online gaming portals that compete with commercial gaming portals.  SGMS, a strong player in the lottery industry, did not have a strong presence in the casino industry.  In particular, it did not have the large content library that WMS had.  With the acquisition, SGMS could leverage that content and expertise in the casino industry to better position itself with the disappearing boundaries between lotteries and commercial gaming, both online and offline.

Revenue synergies: SGMS’s weakness is WMS strength and vice versa

First, SGMS had fairly weak content given their focus on developing lottery systems rather than electronic gaming content.  Its gaming segment typically catered to basic pub-style video lottery terminals as opposed to high-end casino floor machines.  SGMS could leverage such content across its platform and drive incremental revenue.  The platform itself is expanding as both government entities and operators are introducing online offerings to end consumers. With the recently extended contract with Delaware, SGMS is operating its gaming portal, but can leverage WMS’s content to that site.  In Illinois, lottery tickets can be bought online while New Jersey residents can gamble at online casinos.  The most competitive suppliers will be able to offer not only highly-reliable lottery ticket systems, but also advanced online platforms for states to drive incremental revenue.  The omni-channel strategy increases reach to a consumer’s wallet. 

The reverse synergies are just as important.  WMS was weak with networked systems, an area of strength for SGMS.  For example, SGMS systems could be sold to casino operators, WMS’ traditional customers. 

In addition, WMS generated less than 20% of its revenues from international sales, whereas SGMS generated 45% of its revenues internationally.  SGMS has a larger international salesforce that can leverage and cross-sell much better content and machines into channels.  For example, SGMS will likely add WMS content to its Ladbrokes contract and drive incremental revenue with the better content. 

Cost Synergies
SGMS’s prior management team had targeted $50M of cost savings in Year 1 and $100M in Year 2.  Of the $100M target, $60M would come from SG&A and $20M from COGS and R&D.  The majority of SG&A savings would be realized through eliminating duplicative roles and public company costs such as two management teams, two boards, two public accounting firms, etc.  For R&D, SGMS has software development teams in Georgia, Germany and Austria, while WMS has a team in Pune, India.  So there will be some consolidation towards lower-cost development jurisdictions.  The COGS synergies primarily come from consolidating manufacturing and applying SGMS’s low-cost procurement process onto WMS machines.  The company assumes it can take $1,000 of costs out per machine and WMS ships approximately 20K machines per year, resulting in $20M of cost savings.

The analyst and investor community initially met the cost savings number with skepticism as they had little faith in the former management team given past failures.  However, SGMS was given a 9 month head start to plan for the cost savings while it received regulatory approval for the acquisition.  As of its Q4’13 earnings announcement, it had realized $45M in cost savings within the first five months and raised its target from $50M to $60M for 2014.  It is ahead of its original plan, which has tapered some skepticism.

Valuation of SGMS Common Stock

Revenue Assumptions – FY14/FY15

1. Lottery segment: In FY14 we assume core growth equal to GDP/year (~ 3%) plus upside from the New Jersey and Greece contracts that should roll out through 2014.  The NJ contract could generate $17M in revenue as it did for the prior vendor while Greece will be a much bigger contract.  In FY15 we assume growth equal to GDP. 
2. Gaming segment: In FY14 we expect services revenue (participation + interactive) to grow double digits.  Participation is expected to grow at 4% y/y based on most recent quarterly results, while interactive to grow at 10% sequentially q/q as the daily active user base grows.  We assume product sales will grow ~ 1%/year as the Blade product negates tougher comps. In FY15 we assume participation revenue to grow 3.0% y/y, interactive to grow 5% sequentially q/q as older apps mature and product revenue to grow 1%.  Overall, the segment should grow organically mid-single digits. 
3. JV EBITDA of $100M is based off Q4’13 run-rate result of $105.6M.  We do not grow JV ebitda in 2015.

Margin Assumptions – FY14/FY15

In terms of gross margins, we have maintained Instant and Lottery gross margins to be flat from 2013 as we do not expect any significant changes (other than cost savings plan, which is included in a separate line item).  For operating expenses, we project Instant and Lottery to decline 30 bps in FY14 and 20 bps in FY15 as we expect some operating leverage to occur through top-line growth. 

For Gaming gross margins, they should improve primarily due to revenue mix from WMS’s higher-margin revenues vs. SGMS’s gaming revenues, hitting nearly 60% in 2014 and 61% in 2015.  Similarly, we expect gaming operating expenses to move to mid-30% based on a pro forma combination of the two companies. 

Other Expense Assumptions (includes cost synergies, interest expense, cap ex) – FY14/FY15

When SGMS closed its acquisition of WMS, it was expected to achieve $100M in run-rate cost savings and $20M in Cap Ex synergies by the end of 2015.  This was considered a lofty goal, but the company is ahead of schedule, raising its 2014 cost-savings target from $50M to “at least $60M” and has achieved $45M so far.  Analysts still have some skepticism on reaching the target, but margin of safety in the business model is high.  We assume $60M for 2014E and $80M for 2015E.

The company forecasts $173M in interest expense, but will likely refinance two tranches of senior notes that will reduce this interest expense (more details in a later section below).  Capital expenditures are expected to be $280M in 2014, while working capital is $40M and cash taxes are $24M based on company earnings calls and presentations.  We also added a JV EBITDA cash flow conversion to discount the JV EBITDA in the FCF calculation.  Historically, cash flow from JVs are approximately 50-70% of JV EBITDA, so we apply a 60% conversion rate.  Note that SGMS has a significant NOL balance ($144.1 million federal, $36.3 million state and $56.2 million foreign) that shields it from cash taxes. 

EBITDA and FCF – FY14/FY15

We anticipate that SGMS will generate $100M in EBITDA from joint ventures, which results in $641M in EBITDA.  These projections are about 5% higher than consensus estimates as we expect some operating leverage from revenue growth and a shift away from low-end, low-margin gaming machines in the WMS segment.  This results in $94M in FCF for 2014 or $1.11/share and will hit a run-rate of $2.00/share in Q4’14 once cost savings and interest expense savings kick-in.  Extending our model to 2015, which assumes single-digit growth and conservative run-rate cost savings of $80M, we expect SGMS to generate $2.32/share in FCF or a 20% FCF yield to equity at the current price of SGMS common. 

Valuation Summary - Comparables

In terms of comparing valuations to IGT and BYI (SGMS’ closest competitors), SGMS is trading at a discount on an EV/EBITDA basis, 6.2x/6.8x/9.5x for 2014 and 5.7x/6.3x/8.7x for 2015, respectively. 

EBITDA Multiple Valuation

Base case, SGMS should trade at least above IGT given that SGMS 1) drives 50% of their revenue from their sticky lottery customers and 2) grows their market share of the gaming business (at IGT’s expense).  Applying a 7.5x multiple to SGMS FY15 Ebitda would result in $26 /share. 

The upside case is that SGMS re-rates above BYI and gets credit for its recurring lottery revenue base, diversified exposure and future growth prospects.  A 9.0x multiple would rate the stock at $39/share.

FCF Yield Valuation

SGMS currently trades at a 10% 2014 FCF yield and 20% 2015 FCF yield, offering a strong margin of safety.  SGMS trades at a significant higher FCF yield as compared to competitors despite being more diversified.  We think a conservative valuation would be a 10% FCF yield on 2015 estimates which results in a $23/share stock price or 100% upside from today’s current price. 

Summary Bear Case Arguments:

#1:  The prior SGMS management team poorly ran the company by making numerous acquisitions over the years without a clear strategy and had poor relationships with the Street.

What Bears are missing: 

New management team will provide greater transparency for investors and better decision making.

The former CEO, A. Lorne Weil ran Autotote, which acquired Scientific Games in 2000 and assumed its name, from 1992 until 2008 and 2010-2013.   Under Lorne’s watch, the stock peaked above $37 in 2007 and has traded significantly below ever since.  The management team did not provide guidance or set public goals that would hold themselves accountable.  They consistently made acquisitions and used equity investments to direct corporate strategy with no discernable long term goal.  It has been very frustrating for analysts and investors.  

Ron Perelman, a long-time shareholder, has recently forced change at the management level.  He replaced the former CEO with David Kennedy, former CEO of Revlon, who has an extensive consumer background at Revlon and Coca-Cola.  His employment contract is 1-yr, which implies that he is acting as interim CEO while they search for a more permanent CEO.   

Most recently, the CFO and Head of IR were also replaced.  The Street and investors found these former representatives to be very difficult to work with.  For example, the Stifel Nicolas analyst has noted that SGMS suffered from the suffered “ineffectiveness in clearly articulating expectations to the Street and then operating the business against those expectations.”  The new CFO and Head of IR were part of WMS and were well-liked by the street.  Scott Schweinfurth (CFO) and Bill Pfund (VP of IR) were named Best CFO and Best IR Professional, respectively, in the Gaming and Lodging industry by Institutional Investor Magazine from 2009 to 2011.  We expect this investor-friendly management team will bring renewed focus, improved investor marketing and greater transparency. 

One important observation to note is that under the new management team, SGMS repurchased $29.5M shares in the first 2.5 months of the year when the stock traded down.  This is a strong signal that illustrates that the new management sees the stock as substantially undervalued and is not afraid to repurchase shares despite their leverage. 

#2:  The regional gaming industry is weak and is impacting gaming manufacturers.  IGT, the leader in the space, is facing serious issues and is a sign of things to come for other players

What Bears are missing: 

Misinterpreted gaming industry dynamics that over-penalize SGMS will dissipate as the company executes.  SGMS/WMS is outperforming peers. 

Recent fears regarding weakness in US regional gaming have impacted slot machine players such as IGT, BYI and SGMS (by virtue of owning WMS).  The cold weather this past winter impacted traffic across all regional casinos and lead to lower revenues.  We believe bears are interpreting the temporary declines as a precursor to a shrinking business model. 

First, SGMS has traded in strong correlation to IGT and BYI over the last several months despite the fact that only 50% of SGMS combined revenues are related to gaming, while the remaining are related to long-term recurring revenue lottery contracts.  One of the issues facing SGMS is that it is covered by gaming analysts on the Street who don’t understand the lottery side of the business (and the prior management team’s weak relationships with the Street did not help), resulting in poor coverage and automatic grouping into gaming manufacturers. 

The second misperception is due to weakness in other players.  The market leader in the space is IGT with ~40% US slot share while Bally, Aristocrat and SGMS/WMS have 10-15% each.  IGT’s CEO is pursuing a strategy that focuses on investing and expanding its online gaming casinos and apps while harvesting its traditional slot machine business as a cash-cow.  Thus, just like in any industry, the innovators are taking advantage of this complacency and capturing market share from the large incumbent.  Given IGT’s size, it is seen as the barometer of the industry’s health even though the likely dynamic is that IGT is losing market share to others as part of a deliberate strategy.  IGT missed earnings the last two quarters and most recently cut their EPS guidance by 20%.  The entire sector was hit on these three successive negative announcements, and SGMS was dragged down despite having financials trending in the opposite direction. 

One of IGT’s most profitable segments, GameOps (‘participation’ or revenue-sharing slot machines) revenue, fell 8% y/y in the last quarter.  The company blamed weakness in regional gaming as the main factor, and therefore investors associated IGT’s weakness as a signal that other competitors would also face similar distress.  IGT did not attribute a significant portion of its underperformance to competition.  But the numbers tell a different story.  IGT’s revenue from this segment has had negative y/y growth for the past 8 quarters.  WMS launched Gamefield xD in Q1’13 and has had three straight quarters of y/y growth. 

An important note regarding the growth of participation revenues is that it leads to growth in capital expenditures.  WMS recognizes its Gamefield xD machines through capex given that these machines are leased to casino operators.  Investors can get confused and concerned by the growing capex numbers, but much of it is attributable to these lease contracts, which have highly attractive economics and margins. 

Channel checks have indicated that IGT is losing US market share to other players such as WMS and the results are appearing in the numbers.   Once investors begin to understand the gaming industry dynamics that SGMS is taking market share (and has a diversified revenue base), SGMS’s stock should decouple from IGT’s stock and poor performance.  

#3:  The gaming segment top-line numbers indicate a downward trend. 

What Bears are missing: 

Bear thesis expecting negative top-line growth on the company’s gaming segment is overblown. SGMS/WMS is at the beginning of a growing product cycle.

A common bear thesis that the gaming segment revenues will not grow due to increased competition.  However, there are reasons why the gaming segment has a good future. 

First, WMS has been taking market share with its high-quality Gamefield XD (GameOps revenues) and Blade (Product revenue) machines and the economics suggest that they will continue to increase market share.  For example, a Blade cabinet costs approximately $5-6K more than a cabinet generating ‘house average’.  According to the company, Blade cabinets generate 1.3x the house average in terms of revenue.  House averages can range as low as $100/day in large Vegas-type casinos up to $700/day at tribal casinos.  For a $200/day house average, the Blade cabinet could generate an incremental $60/day. The $60/day uplift can payback the $5-6K premium for the Blade cabinet in ~3-4 months, which is very attractive given its multi-year lifespan.  Thus, there will be continued strong demand for these high-end cabinets. 

Bears will point to the significant decline of -22% in Q4’13 product shipments as a sign of collapse.  But digging deep into the numbers, Q4’12 was an anomaly where WMS was shipping lower-priced VLT units for a one-time contract in Canada.  Excluding this contract, y/y unit growth was -2% while ASPs grew +1%, hardly a collapse.  We think this was poorly communicated to the investor community, but expectations have been reset to a core baseline unit shipment. 

The key focus will be the growth of the high-end Blade cabinets, which launched in Q1’13.  It has become a significant portion of total shipments (42% in Q4’13) as the company moves away from lower-end, lower-margin cabinets.  We expect the Blade cabinet to have a multi-year product cycle (WMS’s prior-generation game, BlueBird, launched in 2008) and growth to continue.  The launch of a mechanical-reel version in Q2’14 should continue to add to short-term growth.  For example, BlueBird 2 has cumulatively sold over 70K units since 2008 with a peak of 20K units sold in 2010.  Blade has sold 6.6K units WMS in its first year. Furthermore, expect margins to improve as manufacturing scales through the product cycle.

Another upside option is the potential international revenue opportunity.   WMS was a weaker player in the international market.  Leveraging SGMS’s international salesforce and exposure could open a significant revenue opportunity in gaming places such as Macau and Asia in general.  This synergy is not priced into the stock as management has not given a magnitude of this opportunity.

Last, the Interactive segment launched in mid-2012 has hit a $112M revenue run-rate in Q4’13, growing nearly 100% y/y (more explained in a separate section below).  This will become a substantial multi-year growth driver for the gaming segment and is quite often overlooked. 

#4:  The lottery business is highly competitive and margins will compress.

What Bears are missing: 

The lottery business generates recurring revenue under long-term contracts and secular trends are positive.

SGMS’s lottery segment has been historically viewed as ‘unsexy’ given that top-line growth compounds in single-digits.  The truth is that the business is a recurring revenue model that generates consistent cash flows under long-term contracts.  Contract terms generally range from 3-15 years and are often embedded with customer renewal options.  The revenues are generally linked on a participation based model, where SGMS receives a portion of tickets sold, or a software & maintenance model if systems are provided. 

This model is highly recurring given the underlying industry dynamics where consumers consistently purchase tickets every year.  According to the NASPL, US lottery sales have grown from $58.2bn in 2009 to $68.8bn in 2012 or a 4% CAGR.  In fact, US lottery sales have grown 14 of the last 15 years (2009 being the outlier) at a rate faster than GDP.  The most recent driver of growth was Powerball’s ticket price increase from $1 to $2 in 2012, which contributed to the 9% US lottery sales growth in 2012. 

There are several major secular trends that will provide a long-runway of growth opportunities.  In the US, lottery privatizations and private management agreements are increasingly popular as states attempt to find ways to grow their lottery sales to help close budget shortfalls.  Many lotteries are evaluating options to outsource lottery management to vendors with incentive payments tied to growth.  Private vendors such as SGMS have deeper expertise and operational experience that can drive lottery growth better than state-run systems. 

Bears will generally point out to SGMS’s Illinois 10-yr contract win in 2011 as how lottery contracts have gone awry.  Illinois was the first state to undergo a private management agreement (PMA) where it outsourced the management of its lottery system.  Under the terms of the contract, the supplier gets incentive compensation above a hurdle rate or must pay the state if not achieved.  SGMS structured the bid for the contract such that it would knowingly lose money the first few years while generating profits in the outer years.  Of course, this was poorly communicated to investors by the prior management team, and the upfront losses became perceived as permanent losses for the entire contract.  Although it is hard to predict when the contract will generate profits (likely midway through the contract), most assume the worst and any improvement would be seen as a positive.

The ancillary benefit of the Illinois contract was that SGMS became a stronger bidder by having experience with a PMA contract.  This enabled them to bid for New Jersey’s contract and win, which is expected to be profitable year 1.  According to New Jersey’s annual report, it had paid $16.7M in instant ticket vendor fees, which gives a good estimate of this opportunity for SGMS.  As states move towards privatization, SGMS will be well positioned to win these contracts.

Another trend is a global opportunity where countries are also evaluating new sources of revenue through lottery systems.  For example, Greece awarded a 12-yr contract to consortium that included SGMS where SGMS will be the provider of instant tickets.  There are multiple opportunities on the horizon including countries such as Brazil and Turkey.

Catalysts

Revenue synergies

The company has not quantified any revenue synergies even though there is clearly cross-selling leverage in the model.  WMS primarily generated revenues from the US (>80%) while SGMS has had a much larger international revenue base.  SGMS can leverage WMS’s content and high-quality hardware to bid on more contracts with a full end-to-end solution.  Embedded in SGMS’s most recent Delaware lottery contract extension included an “installation of a minimum of 450 WMS multi-game VLTs.”  This is a sneak-peek of potential new contracts to come which provide upside that is not priced into the stock. 

Near-term debt refinancings

SGMS also has several senior notes outstanding and has two in particular that are up for refinancing.  There is a $350M 2019 9.25% senior note callable on 6/15/14 and $250M 2018 8.125% senior note callable on 9/15/14.  We think that SGMS will refinance these notes at 5% given that its longest dated note due in 2020 note is trading at 4.85% today.  If these are successfully refinanced at 5%, it would generate $22.7M in annual interest savings that flows directly to FCF.  This refinancing catalyst is not mentioned by analysts but it is clearly a possibility given the high coupons and window to attractively refinance. 

WMS Interactive (online gaming) with near-term catalysts.

WMS has a hidden gem that is completely overlooked by analysts and investors as the unit is embedded within gaming services.  The prior SGMS management team has rarely mentioned this unit, but has grown it organically unlike IGT’s spending spree which resulted in a $500M acquisition of DoubleDown.  The Interactive segment is driven by an app, Jackpot Party Social Casino, which can be found on Facebook, Apple and Android platforms.  It also generates revenue from real-money gaming by providing content to online operators.  This unit launched in mid-2012 and continues to grow at a rapid pace.  The social casino game generated $14M in revenues for Q4’12, which grew 95% to $28M in Q4’13.  There will be continued growth as future games are launched (Goldfish Social Casino launch in Q2’14).

Observing IGT’s Interactive unit (which it had acquired instead of organically growing), it generated $75M in revenues for Q4’13 with a 41% growth rate and 63% gross margin.  WMS Interactive likely has a similar gross margin profile (app stores take 30% of total revenue).  When IGT began to focus on developing and marketing its interactive unit, it lured tech investors who were looking to get exposure to online gaming opportunities (and potentially hedged against traditional players such as BYI and SGMS/WMS).  Few investors know that WMS has a fast-growing online gaming segment and that its return on capital is substantially higher than IGT’s given WMS has grown it organically while IGT has been on an acquisition spree.  WMS Interactive has had no more than a quick mention, but this is likely to change as investors take notice of its high growth rates and large un-monetized content library.

An exciting near-term catalyst, the Interactive segment announced a contract with Bwin.Party to provide online slot content for New Jersey’s online gaming market.  Given that only casino operators with a physical presence can operate a portal, Bwin.Party is providing  a platform for Borgata Casinos. This contract will provide future growth as Bwin.Party/Borgata is reported to have 40% online market share in NJ.  An important note to be made is that this leverages existing content which leads to incremental margins that fall to the bottom line. 

Additional analyst coverage likely to come

 SGMS has historically had poor coverage on the Street because it rarely fit within any coverage universe and also partly because the investor relations function was poorly managed.  There are no other US public comps that have the same exposure to the lottery business as SGMS, so it did not make sense for analysts to cover a one-off name.  However, the acquisition of WMS will likely lead additional analyst coverage given that IGT and BYI are well-covered by analysts who will likely have to cover SGMS given the overlap.  Whether or not the gaming analysts are the right coverage group is debatable, but nonetheless increased coverage should be a net positive. 

In addition, there is a stale “Sell” rating with a price target of $7 by Deutsche Bank that will likely be revised or fall off.  The history behind the sell, according to the company, was that the DB analyst had a sell rating on WMS (which ended up to be the incorrect call given SGMS’s acquisition) and transferred that sell rating to SGMS.  The company stated that the DB analyst never talked to them and was unwilling to have a discussion with SGMS about the business.  So this turned out to be very poor coverage on the DB analyst’s part for unknown reasons at that time.  Lo and behold, the DB analyst left his job in Feb’14 and transferred coverage.  Now the rating is stale as has not been updated for Q4’13 earnings.  So expect this sell rating and $7 price target to roll off consensus screens or be updated by the new analyst coverage.  Currently, there are two price targets on Bloomberg estimates, $22 and $7, providing an average target of $15.  Once the $7 rolls off, the average consensus price target will shift up from $15 to $22 and should screen more attractively.

Shareholder base is likely undergoing a rotation, causing a temporary price dislocation.

According to Bloomberg, hedge funds owned 15% of shares prior to the WMS acquisition and currently own 23% as of the most recent quarter-end.  There is a material shareholder base of long/short equity hedge funds that own SGMS shares, several of which are heavily weighted to technology stocks.  Given the recent poor performance by hedge funds with high tech exposure, we believe that there is substantial de-risking in the shareholder base that is causing significant selling pressure. 

Furthermore, the former CEO has been liquidating his holdings after being fired in December 2013.  According to the company, it was for tax purposes.  Form 4 filings indicate that he has been consistently selling his shares into the market through today (and we assume his family members who he hired as company employees are also sellers). 

Furthermore, SGMS was unfortunately replaced in the S&P MidCap 400 index and moved to the S&P SmallCap 600 index.  This rotation cause further downward pressure in the stock. 

This forced selling is causing temporary price dislocations on the stock, which presents an attractive entry point for value investors who like to pick up shares from weak hands. 

Catalyst