Description
I believe Scientific Games (NASDAQ: SGMS) is an attractively-valued, growing company, and represents an interesting way to capitalize on the estimated $60 billion cumulative state budget deficit in the United States.
SGMS has 4 major businesses, one of which is in the process of being divested. In Warren Buffett fashion, it holds a dominant position in most of its markets. It holds a 65% market share in instant lottery ticket sales, a 65% market share in North American pari-mutuel handle and also offers venue management division, which owns and operates OTB parlors in Connecticut and the Netherlands. It’s fourth division is a telecommunications business, which is currently being sold by an investment banker. The Company is looking to sell for about 5x EBITDA, or about $1.00 per share. Any proceeds will be used to pay down debt.
The lottery group is comprised of instant tickets, on-line (comparable to publicly-traded GTK), and cooperative services. This is the company’s bread-and-butter business. They supply tickets to 29 US states and 60 international jurisdictions. Revenues in this division were up 28% YOY in Q1 2003 and, because incremental revenues come at little cost, EBIT grew by 48% YOY in Q1 03. SGMS basically is a high-class printer in an industry where barriers to entry are very high (fraud and authentication are critically important to states as lottery tickets are in essence, printing money). SGMS earns a percentage (approx. 1-1.5% of the tickets it sells). However, its cooperative services group (distribution, marketing, etc. of tickets) is gaining significant traction. The argument here is that states are not well-equipped to actually “run” the lotteries. SGMS has proven that when states outsource more functions to SGMS, revenues back to the state increase dramatically. SGMS “take” from states increases to approximately 2.5% of sales when such services are used by the states. It is an incredible way to leverage their relationships in lotteries where they already do the printing and decreases their reliance on signing up new states. This business represents approximately 58% of SGMS’ sales and 65% of EBIT. The lottery group has approximately 34% margins.
The pari-mutuel group installs and maintains pari-mutuel wagering systems and equipment. This business is from the old Autotote, which acquired SGMS in April 2001. The acquisition significantly leveraged the merged company, but the company recently re-financed its debt (summer 2002), and given the strong, recurring (approx. 80% of revenues) nature of the business, the story becomes one of simple debt reduction, aided by what I believe will be 15%+ EBIT growth for the next few years.
The Autotote business is a stable cash-cow, where SGMS again receives a percentage of the total wagers placed over its system. The business grows at about 4% a year and benefits from things such as increased off-track betting and slots at the tracks. This business represents about 19% of revenues and 12% of SGMS’ EBIT.
The company’s third business is venue management, where it operates OTB’s in CT and the Netherlands. This segment represents about 13.5% of the company’s revenues and EBIT. It is another stable cash business that grows at 5-7% annually.
The fourth business is a telecom business (prepaid cards) which is in the process of being divested.
Reasons to like the company:
· Dominant share in each of its business
· Debt Paydown
· 80% recurring revenues
· Recession resistant and state budget deficits are running at extraordinarily high levels. Gaming/lotteries are proliferating
· Business is growing at approximately 12% topline, which translates to approximately 15-20% EBIT growth and 25-30% EPS growth with debt reduction
· Strong free cash flow in excess of EPS due to the fact that D&A exceeds CapEx and the company only pays 18% cash taxes.
· Margin expansion due to increased utilization and migration into attractive, higher margin businesses such as cooperative services. Incremental business is HIGHLY profitable given the fixed cost nature of the gusiness
· Sale of non-core assets
· Stock is depressed for “one-time” reasons (1. the company won an Italian lottery business, that’s not in any of my numbers that could add up to $0.15/annually in EPS, that has been in limbo for about 6-9 months… 2. an employee was involved in a scandal related to a Breeders’ Cup incident, which has been resolved)
Financials:
2003E EBITDA = $149mm
2003E EBITDA Margin = 29%
2003E EBIT = $106mm
2003E EBIT Margin = 24%
2003E EPS = $0.58
2003E FCF = $72mm
2003 FCF/Share = $0.82
I believe this company is trading at 7.5x 2003E FCF and about 6.3x 2004E FCF. It will paydown approximately $50mm of debt this year and is a rapidly growing company. Debt paydown could be accelerated with the sale of non-core assets.
Catalyst
· Dominant share in each of its business
· Debt Paydown
· 80% recurring revenues
· Recession resistant and state budget deficits are running at extraordinarily high levels. Gaming/lotteries are proliferating
· Business is growing at approximately 12% topline, which translates to approximately 15-20% EBIT growth and 25-30% EPS growth with debt reduction
· Strong free cash flow in excess of EPS due to the fact that D&A exceeds CapEx and the company only pays 18% cash taxes.
· Margin expansion due to increased utilization and migration into attractive, higher margin businesses such as cooperative services. Incremental business is HIGHLY profitable given the fixed cost nature of the gusiness
· Sale of non-core assets
· Stock is depressed for “one-time” reasons (1. the company won an Italian lottery business, that’s not in any of my numbers that could add up to $0.15/annually in EPS, that has been in limbo for about 6-9 months… 2. an employee was involved in a scandal related to a Breeders’ Cup incident, which has been resolved)