Description

Scientific Games (SGMS) is undervalued as a number of new business wins will be awarded over the next 12 months resulting in 2007 EPS that is double the $1.04 that will be earned in 2005. Importantly, these new business wins are not in sell-side estimates.

2/1/06 SGMS Share Price: $32.02
FD S/O: 92.9mm
Mkt Cap: $2,974mm
Net Debt: $532mm
TEV: $3,506mm

2004E EPS: $0.89; 36.0x
2005E EPS: $1.04; 30.8x
2006E EPS: $1.50; 21.3x
2007E EPS: $2.00; 16.0x

SGMS operates in 4 lines of business:

(i) Lottery (81% of 2004 EBIT before corporate expenses): SGMS provides instant ticket and online lottery systems. Instant tickets are also known as scratch tickets. SGMS provides instant ticket design and manufacturing as well as value-added services, including game design, sales and marketing support, inventory management and warehousing and fulfillment services. SGMS owns the right to use over 80 licensed brand names on scratch tickets, such as NASCAR, NBA, Wheel of Fortune and Harley-Davidson. Online lottery refers to a computerized system in which lottery terminals in retail outlets are connected to a central computer system. This is used for games such as lotto (e.g, Powerball, with SGMS operating about half of the 27 Powerball states), sports pool and keno. The final segment of this business is software and hardware systems for the accounting and validation of both instant tickets and online lottery games.

(ii) Pari-mutuel (9% of 2004 EBIT before corporate expenses): Computerized wagering systems for the pari-mutuel (horse betting) industry. These services are provided to racetracks, OTBs, casinos, jai alai frontons, etc. In 2004, SGMS systems processed more than 50% of the estimated $20b North American pari-mutuel business. The general term of a pari-mutuel contract is for 5 years with SGMS taking a % of wagers. Because of a general decline in pari-mutuel business (fewer people interested in horse racing), 2005 pari-mutuel EBIT is projected to be cut in half, falling from $16mm to ~$8mm. During Q305, SGMS began consolidating its 17 North American data centers into 2 and its 4 European data centers into 1. The company estimates that it will finish this restructuring in a year and will realize savings of $7-10mm, which should return the business to its prior profitability;

(iii) Venue management (6% of 2004 EBIT before corporate expenses): SGMS has the right to operate in perpetuity substantially all off-track pari-mutuel wagering in Connecticut (11 facilities) and the right to operate all on-track and off-track pari-mutuel wagering in the Netherlands (28 facilities); and

(iv) Telecommunications (5% of 2004 EBIT before corporate expenses): Manufacturer of pre-paid phone cards, which entitle cellular phone users to a defined value of airtime. Prepaid phone cards utilize the secure process employed in the production of instant tickets.

The focus of this write-up will be the instant ticket division of Lottery as this is the primary engine of SGMS growth. SGMS does not provide the portion of its revenue that is derived from instant ticket sales as contracts are generally confidential between SGMS and the state/country, but management has indicated that it is ~60% of lottery sales or ~40% of total SGMS revenue. Assuming that the EBIT margin of instant and online tickets are similar, instant tickets are ~50% of SGMS profits.

The first U.S. online lottery began in 1964 and the first scratch ticket was sold in 1974. Presently the U.S. has 41 states that allow instant ticket sales with average spending of $92/capita ($25.0b of 2004 instant ticket sales). There are 42 states that allow online lotteries and the average spend in 2004 was $71/capita ($22.4b of 2004 online sales). While extremely large jackpots over the past 10 years have allowed online to post modest revenue growth (e.g., the Megamillions jackpot was $315mm on 11/15/05), instant ticket sales in the U.S. have a 10 year CAGR of 8% vs. 2% for online sales. For the year ended June 2005 (state lotteries are on June year-end), revenue growth in SGMS states was 19%. Licensed product (i.e., Harley-Davidson scratch tickets), higher denomination tickets ($10 and $20 tickets), and demographics (young prefer instant to online lottery) have fueled strong growth in instant tickets. Despite recent concerns regarding high fuel prices and a consumer pullback, checks with state lottery systems do not reveal a slow down in purchases of scratch tickets (like cigarettes this is a very addictive product).

SGMS faces 3 worldwide competitors in instant tickets: Pollard Banknote of Canada, Creative Games of Canada and Oberthur Gaming Technologies (OGT) of France. While instant tickets are more popular in the U.S. than online tickets, they are just 10% of lottery sales outside the U.S. resulting in U.S. instant ticket sales representing 60% of the worldwide market. SGMS has 71% of the U.S. market (primary supplier in 27 states and secondary supplier in 2 states; a primary supplier is generally responsible for ~75%+ of tickets) and this dominant U.S. position gives it worldwide leadership in instant tickets.

Within the instant ticket business, there are 2 types of revenue streams that SGMS can be awarded. The first is a standard fee for printing the instant tickets and the value of their security features – this fee is approximately 1% of total instant sales revenue and is applicable to states that manage their own instant ticket lottery. On the other hand, states can outsource all aspects of instant ticket sales. As noted above, SGMS provides value-added services such as game design, sales and marketing support, inventory management and warehousing and fulfillment services. These services are offered under a co-operative agreement, which pays a higher % of revenue; typically 2%-5% of revenue, but closer to 10% of revenue for relatively small lotteries. SGMS prefers co-op contracts as they result in higher revenue and higher margin. States like co-op contracts as SGMS has the same incentive as the state – to rapidly grow instant ticket sales, which results in higher tax collection. At this point, 11 of 27 SGMS primary states have converted to co-op and the vast majority of new contracts signed outside of the U.S. are co-op.

The significantly larger scale of SGMS affords it a cost advantage relative to competitors. SGMS has widened this moat over the past 5 years by lowering the cost of printing a scratch ticket and adding security features by 16%. Of the last 8 scratch ticket contracts awarded in the U.S., SGMS has won 6, including recently winning the state of California from OGT (population of 35.9mm, which is 60% greater than any other state). While one would assume that the very high margins currently earned (2004 Lottery Group EBIT margin of 28%) will attract increasing competition, which will lower long-term returns, this is unlikely. A competitor would need to devote both substantial capital to increase its capabilities in the space (no other competitor offers co-op services) and then bid below SGMS despite SGMS being the low-cost producer. As an average instant ticket contract has a length of 3 years with numerous automatic extensions, it would likely take 5-10 years to win a sufficient mass of contracts (currently SGMS has no U.S. contract up for bid for 18 months).

Therefore, the instant ticket business has a large moat, high margins, and is a recurring revenue stream. Additionally, the instant ticket business is a great source of FCF as very minimal capital expenditures are required, unlike online lotteries in which a vendor must supply terminals to get vendor at the award of a contract. While SGMS does not breakout capital expenditures between instant and online, I estimate that a very high % of instant ticket income translates to FCF.

While I do not project SGMS to post organic instant ticket growth at the 19% rate it did in the year-ended June 2005, instant ticket organic growth should remain strong for the foreseeable future at a rate of 8-12%, particularly given the ability to increase sales in recently won California, which has instant sales of $42/capita or less than one-half of the U.S. average. My projected online revenue growth going forward is low single digits and while pari-mutuel revenue will likely decline ~5%/year, the current restructuring initiatives should generate increased profitability. Venue management and telecommunications should post stable sales and profitability. This results in EPS of ~$1.35 for 2006 and ~$1.55, which is very close to current sell-side consensus.

However, my estimates are $1.50+ in 2006 and $2.00+ in 2007 because of new contract wins. While the sell-side ignores these new contract wins, this is analogous to projecting the EPS of a fast growing retailer while excluding new store openings. As SGMS is the worldwide leader in scratch tickets, it is logical to assume that SGMS will win a fair number of contracts. Taking the base EPS projections that will result from continued growth of existing contracts, new contracts will create 15c-20c of additional 2006 EPS and 50c+ of additional 2007 EPS. There are a number of potential contracts that SGMS has a good chance to win (or significantly ramp) in the next 12 months, but 4 that are very important:

1. Germany – SGMS has exclusive rights to sell instant tickets in Germany as it bought Honsel on 1/1/05, which held this monopoly. At this point, Honsel sells instant tickets to all 16 German states, but sells a very small amount. The e330mm of instant ticket sales in 2004 is just e4/capita, which is significantly below the U.S. and other European countries that sell instant tickets. Therefore, SGMS is working to convert contracts to co-operative services. Instead of earning a small fee/ticket for printing services, SGMS will earn 5% or more of the entire lottery. SGMS has proven in numerous states and countries that they can rapidly grow a lottery. Italy, which SGMS won 18mths ago, has grown from e0mm to e3,000mm run rate (e50/capita) as of the Q305 conference call. Applying these growth metrics to Germany adds 10c to 2006 EPS, more than 50c to 2007 EPS and more than $1.00 to 2008 EPS. At this time SGMS has switched 2 of 16 states to co-op services. Per discussions with SGMS management, SGMS should switch the remaining 14 states to co-op services by the end of 2006. Please see the end of this write-up for a bridge to projected EPS. Finally, on 1/20/06, SGMS announced it would acquire EssNet for $60mm. This Swedish firm focuses on instant & online POS distribution and infrastructure and has contracts with 7 German states which will expedite the roll-out of instant tickets.

2. Mexico – A similar story except that Mexico will involve online lottery, keno and instant tickets. This contract was announced on 12/13/05. While it is difficult to determine the exact size of this all encompassing contract, Mexico has 106mm people (30% larger than Germany). My best projection is for this to add 10c-20c to 2007 EPS and 20c-30c to 2008 EPS depending on how quickly services ramp (unlikely to add any EPS in 2006). As a point of reference, no one on the sell side is discussing Mexico, despite the company's June Investor Day presentation noting Mexico as a potential contract win, newly hired COO/President Mike Chambrello commenting to investors (I’ve heard this comment twice) that he’s most excited about Latin America, and market rumors of SGMS teaming up with Televisa more than a year ago to organize this lottery.

3. Spain – SGMS has already won a region of Spain that has about 20% of Spain's population (Catalunya) and rolled out instant tickets in Q405. They should have an opportunity to win the rest of the country as an RFP is expected in the near-future. Assuming that Catalunya has a successful start, SGMS should be the favorite to win the rest of Spain. Spain’s 40mm residents are rabid gamblers as the average Spanish person spends more than 3x what the average American does. My estimate is that this contract is worth 2-3c in 2006, 10c in 2007, and 15c in 2008.

4. New York State – New York State issued an RFP for its instant ticket business that will be announced on, or shortly after, 2/8/06. New York’s current contract with Pollard expires on June 30, 2006. SGMS management has referenced that the last RFP in the late 1990s resulted in SGMS scoring higher than Pollard on technical aspects (i.e., quality of instant games and security features), but Pollard winning on price. SGMS has indicated that it will bid very aggressively this time, particularly as it has significantly widen its cost advantage relative to Pollard. Conversations with industry consultants give a very high probability (one said he had “no doubt” that SGMS would win) for SGMS to take this contract from Pollard. Even with reduced economics of a competitive bid, this contract should result in 5c of incremental EPS. Unlike Germany, Mexico, and Spain, New York already has a well established lottery resulting in this profitability immediately flowing through SGMS’ income statement.

The combined impact of these 4 contracts on 2007 EPS is $0.75-$0.85. My estimate of 50c+ gives a discount to reflect that SGMS may not win all of these contracts and the timing of these contracts are driven by politics, which may result in delays that I have not anticipated. However, given these 4 contracts and 2 additional contracts (Maryland instant tickets and conversion of California to co-op), I feel that there are multiple ways to win given 6 significant contracts that should be announced by the end of 2006.

As SGMS should earn approximately $2.00 of EPS in 2007 and has a good chance at $2.50 or more in 2008 EPS, this business is currently trading at 16.0x 2007 EPS and 12.8x 2008 EPS. While the exact timing of contract wins cannot be pinpointed, the announcements will be a surprise and other investors will incorporate these incremental earnings once contracts are announced. A 20x multiple on $2.00 of EPS results in a share price of $40.00, which is upside of 25%. Maintaining the current trailing multiple results in a share price of $61.60 or 93% upside.

Finally, your downside is fairly well protected given the barriers to entry and strong organic growth.

Calculation to German EPS:
My model layers in each of the 16 German states with the first state beginning on Feb 1, 2006 (per SGMS press release for Hessen) and second state beginning on Mar 1, 2006 (per SGMS press release for Hanover). I then layer on an additional state each month through May 2007.
States are projected to ramp up at the same pace as Italy, per SGMS guidance. This guidance may be conservative as SGMS has commented that Italy is managed through a JV resulting in decision by committee which has slowed the ramp of Italy. An example is that SGMS was only allowed to introduce e5 tickets last month despite wanting to issue them 12 months ago. SGMS will not have these restrictions in Germany allowing it to quickly introduce high denomination tickets, advertise the lottery, use brand names, etc.
This roll out of states through May 2007 and projected ramp in spending results in a 2007 lottery size of e3,050, which is the same size as the current Italian lottery. This seems reasonable as the German population is 42% greater than Italy and GDP is slightly higher.
I use a fee of 5% to SGMS, which is conservative as management has indicated the average fee will not be less than 5% and a profit margin of 42% per management guidance for the ramp in profitability of contracts (high incremental income as contracts ramp).
e3,050mm
5% fee to SGMS
e152.9mm of revenue to SGMS
42% pretax profit margin
e64.8mm pretax income
e48.6mm net income (25% German corp tax rate)
92.9mm FD S/O
$0.52 of EPS in 2007

Catalyst

1. Win NY State Instant ticket contract on 2/8/06
2. Continue to win German states
3. More fully explain magnitude of Mexico contract (likely on Q405 conf call)