Scientific Games Corporation
Q3 2008 Earnings Call Transcript

Published: 31 Oct 2008

[Operator:]

(Operator Instructions) Thank you for joining us this morning. With us today are Lorne Weil, Chairman and CEO, Mike Chambrello, President and COO, DeWayne Laird, CFO. During this call they will discuss Scientific Games Third Quarter 2008 Financial Results followed by a question and answer period. A replay of the call will be available at the company’s website www.ScientificGames.com for 30 days. As a reminder this call is being broadcast live. Please refer to yesterday’s press release for full details. Before turning the call over to management Scientific Games would like to remind you that this conference call 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 Scientifics annual report on Form 10-K for the fiscal year ended December 31, 2007.

[Lorne Weil:]

Here with me in New York are Mike Chambrello and DeWayne Laird as usual. Joe Wright is dialing in from out of town due to a commitment made many months ago but he will of course be in attendance for the first quarter conference call at the end of February and I think Joe is on a line from which he can not only monitor this call but can answer questions if anybody would like to ask him any. Overall we were pretty pleased with the quarter which by every financial measure was well ahead of the third quarter of last year. Revenue for the quarter was about $292 million up about 9% from the third quarter last year. Revenue from the racing related businesses continued to retard overall revenue growth excluding these business overall revenue for the quarter was up by more than 11% indicating strong momentum in our core lottery and gaming businesses. A similar pattern can be seen in quarterly EBITDA. Adjusted EBITDA in the third quarter of 2008 increased by 21% to nearly $97 million excluding the racing related businesses adjusted EBITDA was up by 26%. On more than one occasion in the past we have discussed the idea that all things remaining equal our EBITDA ought to grow organically at about twice the rate of revenues due to the operating leverage that is inherent in the business. In the third quarter which was relatively free of either acquisition impacts or unusual items we saw these relationships borne out pretty clearly. Earnings per share in the third quarter were $0.27 excluding the asset impairment charge that was taken in the third quarter of 2007 EPS last year was about $0.17. On an apple to apples comparison EPS in the third quarter 2008 was nearly 60% ahead of last year and would of course been even higher still excluding the impact of racing. Considering the deterioration that has taken place in the environment since the third quarter of last year I think we can be confident that our primary strategies are working well. While every measure of performance was well ahead of last year reported earnings were down sequentially somewhat from the second quarter 2008 pretty much as we had talked about on the second quarter conference call. The major contributing factors identified at that time were a seasonal decline in our Italian joint venture income and increase in interest expense attendant to our debt refinancing completed in the second quarter. Given what has happened in the credit markets in the last several weeks thank God for that, and somewhat higher depreciation expense. Having mentioned our bank refinancing let me just take a second and comment on the fact that liquidity wise we are in excellent shape. We have close to $150 million in cash, unused revolver capacity of close to $200 million and bank debt that is scheduled to mature several years out with a very solid bank group JP Morgan, B of A, UBS, Wells Fargo and so forth. At least right now compared to a couple of deals that have happened in gaming in the last couple of days extraordinarily attractive rates which happens to be Libor plus 250 basis points. As Mike will address in a few minutes we’d expect that increased instant ticket sales in China together with associated system revenues would offset a portion of the sequential decline discussed above but because of product introduction, pricing, logistical and inventory issues that were pretty much beyond our control this did not occur as planned. In essence, while instant ticket revenues in China increased modestly from the second to the third quarter we wound up selling considerably more tickets at lower average prices. This in turn negatively impacted both manufacturing margins and for obvious reasons, airfreight costs. On the other hand what did occur as planned was a significant increase in the level of overhead spending in China in advance of and to drive anticipated increases in revenues. We’ll talk quite a bit more about this over the course of this presentation. This further depressed margins. As Mike will explain in more detail we’ve made excellent strategic progress in the last several weeks in the areas of new ticket introduction, price point enhancement, inventory logistics and retailer expansion. We’re confident that the impact of these factors will be strongly felt in the coming months and quarters. As we mentioned in the press release we have substantial production capacity coming on stream in China during 2009 and our goals for new product introduction and retailer expansion we have planed to introduce at least 40 new tickets in 2009 through a network that has just been expanded to nearly 125,000 retailers double what it was roughly 90 days ago. Anticipate that this capacity will be fully utilized. Elsewhere in our instant ticket business in the third quarter we continued to see relatively minimal revenue impact from either the general economic environment based on yesterday’s economic data we now know to have effectively been the start of a long anticipated recession or the record level of oil and associated gas prices now prevailed during much of the third quarter. Indeed all five of our plans from not only full capacity throughout the third quarter but in fact consistently well beyond their rated capacity. Ironically the inefficiencies associated with the situation yet again impacted our costs and therefore margins. Mike will elaborate on this in a moment as well as associated system wide benefit that will accrue once our plant in China is up and running by the end of this quarter. We think that the recent sharp fall in the price of oil will be a boost going forward and help offset the impact of what is certain to be a continued deterioration in the economy overall. As we have pointed out in the past the overwhelming majority of lottery tickets sold in America are sold through gas station convenient store channel. As mentioned in the press release quarterly revenue from licensed products declined year to year largely because of the Deal or No Deal spike that occurred in 2007. Excluding licensing revenues, core instant ticket growth in the third quarter was about 12% and instant ticket same store growth was about 4.5%. Considering the economic climate and the gasoline situation we think the latter statistic is not bad at all. At the risk of seeming to be a little immodest I don’t think it’s unfair to argue that a lot of the sustained growth in the underlying market that we’ve been seeing is driven by in fact the successful execution of our own strategic actions bearing in mind the importance of our market share in the overall scheme of things. Driven by the activation invalidation system in China our lottery systems business had a very strong quarter with revenues growing overall by 14% and gross margins improving from 47% to 48%. Had we not had the anomalous inventory situation in China I discussed a moment ago revenues and margins would have been even higher in the systems business. For a considerable period of time our European and North American lottery systems businesses had been operating on fundamentally different platforms minimizing potential synergies between the two operations and penalizing overall margins. During 2009 we will be introducing a brand new platform that will be common across all marketplaces. We think the system will have tremendous appeal to customers as well as provide substantial internal economic benefits. In fact we have begun as we speak to receive some very important customer commitment to this new system in the European marketplace. Same store sales growth in the lottery systems business was about 5% with virtually all the growth coming from Europe and Latin America. As mentioned in the press release we were especially pleased with the progress being made in Puerto Rico where year to year quarterly revenues advanced by 33%. Whereas two or three years ago we had considered the Puerto Rico system to be one of our seriously underperforming areas, hot spots as we call them in Scientific Games, it has now become one of our very best and most profitable operations. We ought to bear this experience in mind as we consider strategic options for our contract in Mexico which unfortunately once again in the third quarter penalized earnings per share by about $0.025. At the moment we are looking carefully at a range of options for Mexico and we are quite confident that we will reach a successful resolution. By contrast our Global Draw business in Mexico is doing extraordinarily well driven by the above average performance of our gaming systems in that marketplace. As we speak we are in the process of doubling the size of our network in Mexico and we are hopeful that we can continue to grow beyond that to still higher machine levels in Mexico as well as penetrate important new markets in Latin America and the Caribbean. Similarly the performance of the Global Draw system in the core UK market continues to be exceptional despite the vagaries of the UK economy. Here again has been the case in our lottery business we have been able to greatly help our own cause and that of our customers by investing as we have in the development of proprietary new game content which has by now become the major growth driver in our business. We don’t normally release the figures but I can tell you that the performance of our proprietary gain that we’ve introduced on the Global Draw platform since the change in the regulations last year has been absolutely unbelievable. Our progress in converting Games Media from a one time seller of analog products to an operator of a participation based national digital system is obviously not getting any help from the UK environment. The UK consumer economy is weak. A smoking ban is at least for now hurting the pub industry and so forth. Never the less the install base of machines on the network is steadily building and more importantly the profitability of the business is responding beautifully to the change in the business model. Gross margins in the third quarter were 49% up from 10% in the third quarter of 2007 a clear indication of the fundamental difference between being in the one time sale business and being in the participation based systems business. The decline in revenues attended to the conversion notwithstanding. Given the rate that the install base is building together with the visibility provided by the range of contracts currently in house we anticipate that this business will now make a very substantial contribution to our financial performance next year. In fact, I wrote those words that I just read late yesterday afternoon and then yesterday evening, believe it or not, we learned that we have just received a commitment from a major UK pub retailer that will by year end lead to an increase in our install base of both pubs and machines in the Games Media network by 75%, virtually guaranteeing now a major financial contribution from this business next year. We left it up to the very last minute but we made it. As mentioned previously our racing related businesses have tended to average down our overall revenue and earnings performance reflecting both the weakness in the North American racing industry that ironically as well the strength of our other markets despite the environment. Never the less, despite the environment the racing business are operating quite profitably and are cash flow positive they just don’t operate as well as the rest of the business which as you’ve seen is an EBITDA margin better than 33%. The international racing market is considerably more active than the market in the US. We’ll talk of a revival of racing in China beginning to be heard loudly and were this to occur it would fall under the China Sports Lottery. All in all then I think we can say that we’re quite pleased with where we are at the moment notwithstanding some of the inefficiencies that we’re trying to deal with given that we have more balls in the air then we seem to have hands to throw them up and catch them. Our individual lottery and gaming business unit strategies are performing extremely well and our overarching corporate strategy of emphasizing participation based recurring revenue business models and what are fundamentally local recession resistant markets seems to be more than meeting the challenge of the current economic and industry environments. On that note I’ll turn it over to Mike.

[Mike Chambrello:]

That really is great news with Games Media in particular. I’ll jump right into it starting with printed products. The ongoing uncertainty of the economy remains a key issue for us, however, far from the Armageddon situation described in some recent news articles we are seeing same store sales growth in the range of 4% to 4.5% which given the environment we actually think is pretty good. There are two schools of thought on future instant ticket sales. One is that they will soften as a result of the economic downturn and the other which we at Scientific Games are witnessing is a much more proactive approach assumed by a number of lotteries is they are tasked with increasing sales to make up for budget shortfalls in their respective states. For the first time really in quite some time we’re working with lotteries to modify the regulatory requirements or legislations so that they can gain greater flexibility in game design, content, advertising, retailer distribution and price payouts. As an example the Arizona Lottery historically very conservative recently gained legislative approval to exercise at their discretion setting both their advertising budget and price payouts in order to maximize returns to the beneficiaries of that lottery. Just as the environment was right a decade or so ago for changes such as the introduction of cooperative services we believe the current environment will present similar opportunities for product and service expansion. We’re confident that we’ll begin to see the positive impact resulting from this fresh approach sometime in the first half of next year. While a return to high double digit growth is not likely next year we’ll certainly see the opportunity for long term sustained growth. Moving to production and elaborating a little bit on Lorne’s comments, we remain at capacity in each of our facilities worldwide. As stated on previous calls this is generally good news but the lack of operating flexibility that represents continues to reduce our efficiency and adversely impacted our margin this quarter by a percentage point or more likely two. While we did experience the normal seasonal slow down in Europe, Italy and UK as examples, our production was backfilled with lower margin jobs that frankly had been on hold due to our overcapacity situation. In addition, we faced, at least for the first time in my experience penalties with late deliveries or ironically increased costs associated with shipping non-China tickets by year to meet delivery dates in other parts of the world. This, on top of the reduced margin related to our ongoing shipment of instant tickets to China. Interestingly in Q3 our cost of freight in China increased as Lorne described because we were shipping more tickets but at lower price points resulting in higher freight costs and lower margins on these tickets in Q2. Both of these situations will be resolved when we begin printing in China later this year and early Q2 ’09 when our second press is installed and operational. More on China in a minute. In general instant ticket sales remain pretty solid on a seasonally adjusted basis during the summer months which is historically our lowest sales period of the year. We did experience what we believe to be an anomaly in Florida where sales were considerably lower than their historical averages as the lottery focused primarily on the recent competitive bid process and reengineering their product and gaming design process. We expect to return to solid growth in Florida beginning in Q1 2009 however I’ll remind you that probably be at lower margins as the new contract kicks in during Q4 of this year. As a reminder that’s a six year contract with 2-2 year extensions options but the price is fixed over the term. Moving to China, obviously interest remains very high as does our enthusiasm for this market. We remain on track to have our press installed and operating by the end of this year. The second press will land in China in early Q1 and become operational in early Q2. Really not surprisingly sales have declined a bit from their peak pre-Olympic levels. In fact over 95% of all Olympic themed tickets have been sold. It’s an incredible sales percentage in such a short period of time. It really is worth noting however that our highest selling game Lucky Diamonds the 10 RMB game was introduced following the Olympics really reinforcing the broad appeal of scratch games in China regardless of the theme. A strong upward sales trend was interrupted last week when we sold out of the Lucky Diamond game further confirming that the market really demand higher price tickets with their associated price payouts and that inventory shortages do remain a problem. Our focus post Olympics has been to work with the CSL to establish an infrastructure that would expand and improve distribution, increase terminal deployment as Lorne mentioned we now have almost 125,000 retail locations hopefully moving to 150,000 by the end of the year. Probably most importantly we need to develop a detailed marketing and game roll out plan for all of 2009. During and immediately following Olympics we experienced an extended period where game approval and roll out were slower than expected resulting in less product availability in the jurisdictions and retail locations best positioned to sell. As we emerge from the approval process it quickly became clear that the post Olympic game mix specifically price points result in lower than expected retail sales. The average price point during the Olympic Games was 15% to 20% higher than those games launched following the Olympics. The primary driver of this decline was not so much a lack of demand but a less than optimum mix of three, five and 10 RMB games really combined with an uneven distribution and shortage of game inventory. As we continue to move the price points higher margins and overall profitability increased significantly. The difference in profitability between a three and 10 RMB game is immense and increases order of magnitude at even higher price points above 10 which we anticipate in 2009. We are working with the CSL to design a 12 month marketing plan that will include up to 40 new game launches and will include the introduction of higher price point games then we’ve seen in 2008. We also anticipate the introduction of licensed products and merchandise games in 2009. If introduced a game with an NBA theme could be wildly successful the passion for the NBA in China is incredible and grows as each season passes. We expect significant sales growth throughout 2009 in China while we continue to build the infrastructure that will ensure high double digit growth for many years into the future. We continue to compare the China roll out for growth curve to that of Italy. While Italy did not have a launching pad such as the Beijing Olympics we believe we can draw many parallels between the two markets. Italy’s break out year I can use that term was its third year of operation. We have always believed that it would take 12 or so months following the Olympics to get the retailer and terminal density, efficient ticket distribution inventory, higher price points and efficient ticket production in place. While 2009 we should see a very strong growth over 2008 we expect 2010 to be the real break out year. Finally, we’ll be reviewing demand requirements in the first half of next year as we determine our long term press needs. The immediate focus however remains on raising price points, improving ticket distribution and increasing retailer density. The future in China clearly remains very bright. Lottery systems, online lottery sales in the US remain relatively flat while we see continued growth in Europe and strong retail sales growth in Puerto Rico. PowerBall jackpots remain allusive with virtually no jackpot of any impact in Q3. There will however be a major exchange and Florida will joint the Power Ball family in early 2009 so we’re optimistic that we’ll see an increase in jackpot size and therefore retail sales in 2009. We continue to work with lotteries to design and implement aggregated or linked multi-state online games. We believe game show theme games similar to the Deal or No Deal instant game would be equally successful as online games. We believe there’s a pretty good change that one of these games will be introduced in 2009 at a higher than traditional price point providing a refreshing mix of entertainment interaction to the online gaming product portfolio. Pennsylvania, always of interest, but the online procurement process continues to wind its way through the contracting process. As you were aware this contract was originally awarded to a competitor however they failed to get contract execution due to their inability to deliver introduction terminal that they had proposed. The PA lottery entered into and successfully completed contract negotiations with SG this past September. Concurrent with completion of the contract negotiations the competitor activated an administrative bid protest again Pennsylvania. While the Department of Revenue upheld the award to Scientific Games this competitor filed a court action which to date has resulted in a judge from Pennsylvania and joining the commonwealth from proceeding with the contract award to SG until the bid process is resolved. During the protest period we continue to operate under the old contract which is set to expire on December 31 this year using the existing legacy equipment. We’ll continue to work with and support the lottery throughout this process and we remain confident that the contract award to SG will be upheld. Lorne mentioned Mexico, during the last two calls we stated that we will work to end the bleeding in Mexico by year end. We continue to work to resolve this situation by year end. We’ve had some very constructive discussion with Televisa and exploring a number of other creative alternatives that we believe will result in a beneficial resolution to this hot spot very quickly. Finally, moving on to cost and cost structure although our operating performance and cash position remain very strong EBITDA is approaching $400 million annually and as Lorne mentioned we have roughly $150 million in cash balances, almost $200 million on our available line revolver and a high confidence level in our ability to generate significant positive cash flow in 2009. While we’re very well positioned heading into 2009 we are taking the opportunity in Q4 this year to review our overall cost structure. We formed a task force assisted by outside consultants to review our total cost structure and provide recommendations for immediate realistic and achievable reductions in 2009. The role of our consultants will be to review how we are currently operating our business, identify cost reduction and process improvement opportunities, provide the management team with independent data driven analysis to allow us to implement process change and cost reduction in 2009. Our primary focus will include outsourcing in off shoring of terminal manufacturing which is currently underway, centralization of administrative functions including HR, finance, purchasing, payroll, etc. Review and rationalization of all SG&A expenses throughout the company, review and rationalization of our worldwide communications cost structure. I’m hesitant to provide a cost reduction target at this time however we are looking to reduce costs, improve process and ultimately improve our ability to deliver goods and services to our customers. We’ll provide an update on this activity on our next call. With that I will turn it over to Lorne and the group.

[Lorne Weil:]

We haven’t gotten where we’ve gotten the last two years by making things easy on ourselves. On that note operator you can open up the program to questions.

[Operator:]

(Operator Instructions) Your first question comes from Larry Klatzkin - Jefferies

[Larry Klatzkin:]

Could you go over the power of the China price point increases how the margin moves as you increase ticket prices?

[Mike Chambrello:]

As an example if we were to apply June or July’s price points to volume in September and October then our overall retail sales would improve by north of 20%. That’s again assuming that you’re only dealing with 10 RMB tickets which certainly in 2009 we expect to have a higher price point.

[Larry Klatzkin:]

How high could you go on the RMB tickets?

[Mike Chambrello:]

It’s too early to tell and our customers probably would…

[Larry Klatzkin:]

Outlook for Italy next year is there going to be a re-bid in 2010. You guys are linked with LottoMatic is that going to remain in tact?

[Mike Chambrello:]

Sales in Italy obviously remain very strong and we anticipate that they’ll continue to grow into next year. It’s too early in the process to really know and understand what the monopolies plans are going to be. Vis-à-vis a current contract extension, new procurement process etc. I can tell you that our relationship with LottoMatic is very, very strong and we intend and they intend to continue with this relationship through either a contract extension period a new license period and we fully expect and have agreed the consortium remain in tact.

[Larry Klatzkin:]

How many Games Media units could you have in place by year end with everything going on?

[Lorne Weil:]

I would have given you possibly a rather different answer even yesterday then I would today. Sitting here now I would say at the very least a couple thousand and quite possibly considerably more and certainly if not considerably more than a couple thousand by the end of this year then certainly considerably more by early in the first quarter. We’ve talked about before we have this portfolio of contracts where the contracts have trigger points each time we hit a different set of performance objectives. We can pretty much project the thing out based upon how we’re hitting those performance objectives. Again the mindset of the customers because they’re dealing in a very difficult environment. The picture is a very positive one but it’s a question of the pace at which it gets rolled out. You can see how this thing is happening now that it begins to feed on itself and it begins to gather up its own momentum. This thing from yesterday is a very, very important. I know your next question is how much do I think the contribution might be next year. You know what my answer to that would be so don’t bother asking the question. I think its fairly clear now unequivocally that we’ll have a significant contribution from Games Media in 2009 and you saw what the margins were already in the third quarter this year with the revenue a fraction of what its going to be even as soon as the first quarter of next year. This strategy is really starting to take hold. I think I mentioned in the last conference call that I’d been at a customer conference in the UK back in June where I indicated that I got very good vibes from that about where this situation is going. We have another one scheduled for the first week in December which I’m going to be attending again. Hopefully I can come back from that with as ebullient outlook for the following six months. If we just get some reasonable stabilization in the pub environment in the aftermath of the smoking ban. I think there’s probably enough parallels between the UK and United States to say confidently that that will happen. When they first put the smoking ban on bars and clubs in New York every place for several months was a morgue. Now even in the bad environment places that at that time were having trouble getting people to come into them are now literally bursting at the seams. I think most bar owners are again even in this environment experiencing business levels that are considerably better than before the smoking ban simply because with the time lag all the non-smokers start to go out again. I think eventually we’ll see that in the UK and as this pub thing stabilizes and we continue to gather our momentum I think we’re looking at a really fabulous situation.

[Larry Klatzkin:]

You’re talking that Games Media margin in the 40’s and you could have as many as what 5,000 machines by year end?

[Lorne Weil:]

I would expect eventually that the margins might even be a little bit better than that because most of, or a significant part of the global Games Media cost structure or infrastructure actually comes out of the Global Draw infrastructure. For internal accounting purposes and appropriately so we allocate a portion of the Global Draw cost structure whether its communications, field service, content development what have you to Games Media but the fact is those costs really don’t change as the Games Media volume builds. If you were looking at the pure margin absent those internal allocations you might see them going significantly higher than that.

[Larry Klatzkin:]

Could you do 5,000 machines by year end?

[Lorne Weil:]

I think that might be pushing it. I think we might have a shot to be in the range of 5,000 machines early next year.

[Larry Klatzkin:]

I mean year end ’09, sorry.

[Lorne Weil:]

Year end ’09, absolutely. I thought you were talking about year end ’08. Year end ’09 I would be disappointed if weren’t at 5,000 machines.

[Larry Klatzkin:]

Prospects for new Global Draw unit placements outside the UK and the great 10,000 machine inventory you have in a warehouse?

[Lorne Weil:]

Right now we have nothing definitive but a number of very, very active interesting and rapidly maturing opportunities. Let’s just say primarily throughout the Caribbean for the Legacy machines that are in inventory in the Caribbean and in Asia. Just since the last conference call a lot of progress has been made and I really do feel that by the next conference call we will have something important to say about developments in both the Caribbean and in Asia.

[Operator:]

Your next question comes from Celeste Brown - Morgan Stanley

[Celeste Brown:]

Following up on Larry’s line of questioning how many Global Draw machines to you have in the UK and Mexico and then Games Media machines today?

[Lorne Weil:]

Right now we have in the UK we have about 12,000 and change. In Mexico right now we have between 400 and 500 ramping up fairly quickly now to at least 1,000. We have right now as we speak about 1,200 or 1,300 machines in Games Media that will now ramp up before the end of the year as I mentioned a minutes to at least 2,000.

[Celeste Brown:]

The Games Media machines are reflected in the service revenue?

[Lorne Weil:]

They are in the service revenue.

[Celeste Brown:]

What’s the average win per day right now for those three segments? If you don’t have it just for the whole thing?

[Lorne Weil:]

The average win per day for the three segments would be fairly close to what the average is for the UK [Flopteese] because of their numbers are so large in relation to the total. That’s something between $200 and $250 a day per machine.

[Celeste Brown:]

As you roll out additional Games Media games are you going to be able to leverage your existing system or will they be incremental costs in putting in a bigger system?

[Lorne Weil:]

There shouldn’t be very much incremental costs. The system is like all of these kinds of broadband systems this is relatively fixed until you just get quantum increases in traffic then you have to do something completely different. It’s going to be a while before we get to that. I think the way we see the density of the Games Media customers and machines filling themselves in that what is perhaps our biggest cost which is the cost of field maintenance. It’s our biggest cost and it’s also one of our biggest advantages relative to our competition because we’re always hearing how fantastic our service is in those marketplaces. I think we can keep that relatively fixed too. The last time I looked our field technical force in the UK believe it or not. We think they’re very efficient on average they spend about half their time fixing stuff and half their time traveling. Clearly if the new locations are falling in between locations where people are already going then you can clearly spend less time traveling, more time fixing and one guy could take care of considerably more shops and considerably more machines. A point in time would come, maybe when we had as many Games Media machines as we have Global Draw when you would run out of that kind of marginal improvement and have to start to build the organization. We have a ways still before we’ll get to that.

[Celeste Brown:]

What’s the overall margin for the business right now, Games Media and Global Draw combined?

[Lorne Weil:]

I would be around 50%.

[Celeste Brown:]

That’s EBITDA or is that growth?

[Lorne Weil:]

EBITDA.

[Celeste Brown:]

In the past you talked about shuttering or selling the racing business and then with the comments on China today maybe having second thoughts there can you just talk a little bit more about the plans for the business overall?

[Lorne Weil:]

I think the only thing we can say right now is that the plans for the business is to minimize our own CapEx, maximize the earnings, maximize the cash flow which we’re doing and penetrate as aggressively as we can the opportunities that are arising outside the state. Lately we’ve been getting a nice bump from a relationship that we had with a company call Sportech of the UK that’s the dominant player in soccer pools, bedding and I’m sure you’re familiar with them. Of course this possibility in China. In terms of what our longer run strategy is, all I can say is that we’re like all of our businesses we’re regularly, constantly reviewing our options and in the meantime running the business as well as we plan. Clearly it doesn’t have the growth potential that either our gaming business or our lottery business does. On the other hand it provides significant benefits to some of the other businesses. Some of our best Global Draw prospects and indeed existing customers outside of the UK have come through relationships that we had in our racing business and which we might well not have been able to exploit had we not had those relationships. There are a lot of factors at work and I think its just a little premature right now to try to give you any guidance on where we would go with that business in the longer, other than what we’ve already said.

[Celeste Brown:]

On Pennsylvania have you guys already built the machine that you would be installing there and in the worse case could you use them somewhere else?

[Mike Chambrello:]

The answer is we’ve got a partial build. The inventory that we’ve accumulated can certainly be used in other jurisdictions like Cecil as an example. We’ve got a lot of sweat equity in there on the front end of the project but we’re in pretty good shape from an inventory perspective and alternate use perspective.

[Celeste Brown:]

One final question, perhaps a little uncomfortable for asking an executive team but your employee stock option expense increased $3 million quarter over quarter, $8 million a quarter is a big number for a company with the EBITDA you’re generating and I know the plans are to grow it. Can you just talk about the direction of this going forward? Is some of the cost cutting to appear on this line?

[Lorne Weil:]

What it is I think Joe’s on the call and if I think he’s on an extension where he can actually speak and if he has a different view or more information then I’d like to hear from him. DeWayne and I are just looking at each other and what we think it is completely due to Joe’s contract. When we hired Joe as the CEO in waiting who will take over in January Joe received a relatively minimal, I say relatively cash comp compared I think to some of his prior CEO stints but quite a significant stock option and restricted share grant. Normally we amortize our stock option and restricted stock grants over the life of our normal vesting schedule which is five years. Joe’s contract I can’t remember how long it is but it’s considerably shorter than five years. It’s either two or three years. In Joe’s case we’ll be amortizing his award over a much shorter period of time. This in turn produces the result that you’re seeing. DeWayne is saying going forward it should remain flat at that level it should not take another step function increase.

[Operator:]

Your next question comes from Ralph Schackart - William Blair

[Ralph Schackart:]

If we could focus first on the domestic lottery have you seen or maybe you can’t measure at this point, have you seen any uplift since the gas prices have decreased in recent weeks at all?

[Lorne Weil:]

If Mike doesn’t mind I’ll ask Mike to answer that question because he’s actually a little closer to that than I am.

[Mike Chambrello:]

We saw a lag when prices went up and we expect to see a lag now that prices have gone down. We haven’t seen any material change with the dip over the last few weeks. Certainly as we get through November and into December and we see the holiday historically we’ve seen an up tick in instant sales during the holiday season. They don’t start quite this early but if there’s going to be an up tick it’s probably going to be something that we’ll see more sort of in the middle of November then the balance of the year. At this point it’s probably pretty close to the same. We didn’t see huge deteriorations either when they spiked back up in the summer. It’s such a high proportion of our players do buy out of gas station environments we expect we’ll see a bump back. We just haven’t yet.

[Ralph Schackart:]

Have you seen just from a big picture have you seen a big mix shift trend to perhaps lower priced tickets domestically? Have there been any big issues mix wise by geography across the US at all?

[Mike Chambrello:]

Its actually interesting the answer is no we really haven’t. It brings up a good point. If Tim Kennedy our head of sales and marketing were on the call I think we would say very, very strongly that in instances like Arizona that I mentioned earlier where they’re taking a very proactive approach to price payout and to advertising and to actually executing best practices in a full service, full line approach that we said games use. The more proactive people are going to be the higher sales are going to grow that won’t be consistent across lotteries regardless of geography. What you see, about a third of the lotteries we think really catching on and becoming much more proactive over the next new months then that middle third will be a little bit delayed behind them. The more conservative “bottom third” may or may not jump on this proactive bandwagon.

[Ralph Schackart:]

The addressable market opportunity in China can you give us a sense what the addressable market is given the retailers that you have in place at the end of ’08 and what your addressable market big picture would be perhaps by the end of ’09 as we enter into 2010 and beyond?

[Mike Chambrello:]

If you’re referring sort of addressable market as it relates to retailer penetration.

[Ralph Schackart:]

Actually more specifically to population.

[Mike Chambrello:]

Retail penetration as a result of population. I don’t know. I’d say we’re maybe addressing sort of a quarter of a billion of the population now 250 million or so and we would look by the end of next year based on much better distribution, much higher retail density, much better sales and marketing programs that certainly we would double that as we enter into next year. Again I often refer to 2010 as the break out year and I think the addressable population to use that term in 2010 could be significantly higher than half a billion.

[Ralph Schackart:]

Can you help us think about the cost structure to get that 2x growth? Obviously in the short term here you have to put some expenses up front or greater change in the revenue. Would that shift where we could just get to a point where revenue is going to be growing in excess of costs at that point?

[Mike Chambrello:]

Absolutely, when we talk about this super retailer model that China is employing it doesn’t mean that you have capital associated with every retailer and Scientific Games is only responsible for like 90,000 devices. As we head into ’09 and again 2010 I think super, super high margin incremental margin on every incremental dollar of sales.

[Ralph Schackart:]

As it relates to Games Media obviously significant increase in the trajectory of margins. How should we think about that trajectory or the sustainability as you reinvest in that business? Are the margins on path to continue to increase or will there be investments in the business where in a quarter there could be some compression as you try to build for the roll out there?

[Lorne Weil:]

I can’t think right now of any particular significant let’s call it expense investment to obviously draw distinction from capital investment that we would need to be making as we continue the global Games Media roll out. Therefore, I wouldn’t anticipate a high likelihood of any sudden margin compression in Games Media. In terms of the fundamental gross margin of the business itself the interesting thing is that the contracts are in effect self regulating in terms of the margin because the roll out doesn’t occur if we don’t it the performance trigger points. If we hit the performance trigger points then the contracts are designed to give us the target margins. Going out and buying business by compressing the margins is not something that our plan contemplates nor something that any of the contracts contemplate. Having said that I’ve come to know this business quite well but I don’t know everything there is to know about this business and it’s certainly within the realm of possibility that the management of Games Media would want to do something at some point to help accelerate the roll out. Right now I wouldn’t anticipate that.

[Operator:]

Your next question comes from Bob Evans - Craig Hallum

[Bob Evans:]

I apologize if I missed this at the very beginning. Can you give us a little bit of sense of how we should think about Q4 versus Q3? For example, equipment sales down sequentially Q3 versus Q2 how should we think about Q4 as it relates to equipment sales?

[Lorne Weil:]

Equipment sales is largely Cecil there’s where we saw the bump and the decline. We expect to have continued sales really in Q1 and Q2 of next year and not much in that regard for Cecil in Q4. That’s really the big driver.

[Mike Chambrello:]

Let me just add a little bit of color on that too. It’s important we had significant sales to Cecil which decline in the third quarter but if you go behind the sales and look at the margins the profit contribution was relatively minor. I think one of the main benefits of having a few months of hiatus and resuming the shipments in the first quarter of next year is it will give us a chance to implement some quite important cost reduction programs we have such that when we begin to ship again in the first quarter it should be a considerably higher margins than it has been so far this year.

[Bob Evans:]

If we’re thinking about Q4 were you thinking more flattish with Q3 or a little bit of a down trend? This is how sometimes we get off on our revenue models so I just want to get a greater sense.

[Lorne Weil:]

I think certainly as far as equipment sales go I would think down from the third quarter.

[Bob Evans:]

I assume as it relates to service sales we should see sequentially up given that you’re at a stronger seasonality period. I don’t know if I’m missing anything.

[Lorne Weil:]

Certainly the biggest plus going sequentially from the third quarter to the fourth quarter is Italy. Both in terms of ticket sales to the Italian consortium and our share of the consortiums profit.

[Bob Evans:]

How should we think about China sequentially net net? Third quarter you had some of the benefit of the Olympics but then you had some of the negative of the switch over.

[Lorne Weil:]

I’ll let Mike answer that from the point of view of his being much closer to it than I am. From an analytical point of view we’re still trying to sort that question out because it really is a question of how quickly all the different steps. If you’re trying just to build a model just of China that Mike talked about in terms of the retail distribution, moving the price points, getting the games approved, getting the inventory into the pipelines and so forth. Mike mentioned that the biggest selling game we’ve had since we started was this 10 RMB Lucky Diamonds. We just can’t keep the thing in stock. We produce as many as we’re asked to and clearly there has been a disconnect between what the market wants and what we’re producing and shipping. We had three or four weeks of really good week by week by week sales, 20%, 30%, 40%, 50% increases driven among other things by this tremendous demand for this game and the high price point. Them bam we were out of inventory last week and we saw our first weekly dip simply because this product was not available. I think Mike would say as we move into the first quarter certainly into the second quarter when a lot of this stuff gets worked out and particularly as we’re producing this stuff in China. The path from where we are now to the end of the year given these number of variables that we’re in the process of trying to nail down it is just I know it’s not a very satisfying answer but its even more unsatisfying for us sitting here trying to manage it. Having said that let me ask Mike what his view is.

[Bob Evans:]

Maybe add to that when you’re discussing it just not only revenue but maybe how we should view the service margins is it somewhat comparable to this third quarter or did things improve?

[Mike Chambrello:]

Certainly in the fourth quarter we would expect them to be similar. We wouldn’t expect improvement because not enough will have changed. To add on to Lorne’s point, we’re in the fourth quarter we’re going to begin the transition to in country manufacturing. That’s going to take a while to scale up. We think that we in working with the CSL they know and understand or beginning to know and understand the value of different price points. I would say that I would have much greater confidence if we were following on with another one or two 10 RMB games immediately following Lucky Diamonds but given the approval process that didn’t happen. It’s a matter of when will the next one or two 10 RMB games hit the street. I expect that they will before the end of the year. Will they hit the street in time to material impact retail sales? That’s a question to Lorne’s comments; we just don’t have the answer. As we transition into Q1 again the sooner we can get this 40 game 12 month plan in place and approved the better we’ll be able to predict sales on a go forward basis while again we spend at least Q1, Q2 maybe part of Q3 next year building out the marketing team, building out the infrastructure and getting both presses up and operating on a much more efficient basis then certainly shipping tickets from the US. Also we’ve got a 12 hour time difference that we deal with. We’ve got a lot of language issues that we deal with in dealing with the US versus China. We see those working themselves through late this quarter and early next year when all these pieces fall into place its going to be very, very, very great business for us.

[Lorne Weil:]

I think it’s really important to really try to understand and visualize what Mike is talking about. The situation we have now is and its been going on since March is you run some China then you run some stuff for all your other customers then you run some China then you run some stuff for all your other customers then you run some China then you run some stuff for your other customers. It’s like a bunch of one arm paper hangers running around down in the plant. You have issues of start up costs and scrap costs and waste and delay and all these other manufacturing parameters that basically we’ve thrown out the window with the focus simply being what we’ve got to do is try to keep as many customers as we can including China satisfied until we have the capacity in China. Once that happens the whole US manufacturing operation can go back to running the way it’s supposed to. Again no one asked it in this call but I’ve certainly been asked in direct conversations with people we had the margin deterioration during the period of time that we were absorbing the OGT acquisition and then we in terms of the theoretical model had a significant improvement in manufacturing margins once the consolidation of OGT was complete and we haven’t really seen that. The reason is because its funny how things are the completion of the consolidation of OGT which really was once and for all done at the end of the first quarter of this year coincided almost exactly with the Chinese fire drill that no pun intended that erupted when the business in China started. We haven’t ever had a month let alone a quarter when the manufacturing process would have been allowed to settle into its normal state of affairs that would have been the case at the conclusion of the absorption on consolidation of OGT. We just won’t see that happen until the plant in China is capable of being self sufficient and supporting the Chinese business then you’ll see two things. You’ll see a huge improvement in the margins on the Chinese business and you will see a very significant improvement in the margins on all the rest of the business because now it will be able to go back to being scheduled, run and managed in the most efficient way which as I said it has not been the case really since, when did we start to produce for China, February.

[Bob Evans:]

Its early days in China and we should assume inefficiencies for the next quarter or two but dramatic improvement as things run.

[Lorne Weil:]

Exactly.

[Bob Evans:]

SG&A was down markedly sequentially Q3 versus Q2 how should we view that going forward?

[Lorne Weil:]

That’s clearly one of the areas that we’re focused on in this cost initiative that I mentioned. We did take some action at the end of Q1 I think of this year when we recognized that we were having cost creep there. I think certainly our objective is not only to keep it flat but to reduce it going forward. Having said that if you look at the cost of getting China up and operating over the next few quarters that’s going to be higher than it will be over the long term. We’re focused on it and we understand and recognize we have to drive it lower.

[Bob Evans:]

Will those China costs be more in SG&A or more on the margin?

[Mike Chambrello:]

It’s a combination of both and DeWayne can correct me on the exact accounting. I sort of look at SG&A as if we want to drive to the density that we need to in China for terminals, etc. if we want to ensure that the right provinces are selling the right games with the right marketing approach then we’re going to have to build out a field network in China that we would consider SG&A and certainly we’ve got the same management we go purchasing, etc. that’s got to be done out of China. We’re ramping that up through the end of this year and that SG&A will increase but as Lorne mentioned we just need that foundation to get through 2009 and build for 2010.

[Bob Evans:]

The Games Media or the Global Draw if we want to look at that just on a rev per unit annual for more of a mature machine what would be the ranges for both the Global Draw machine and a Games Media machine? Not the win per day but the rev.

[Lorne Weil:]

Unfortunately there we’re getting. I was anticipating that someone would have asked about this general question in the course of the conference call this morning. That is the subject of the exchange rate between the dollar and the main currencies that we do our business in. As you know all of the Games Media and Global Draw revenue is in Sterling. In the last few days we’ve seen Sterling actually coming back but generally say compared to where it was six or seven or eight or nine months ago it’s a little weak. A year ago I would have said the target was around roughly $6,000 per year per machine and now that’s probably closer to $5,500 some number in that range.

[Bob Evans:]

For both Games and Global?

[Lorne Weil:]

Yes, we have virtually the same exact target revenue per machine to us in global and Games Media. At the present time in the pub business, come back to the question that Celeste asked earlier the win per day in the pub business is lower than the win per day is in the [Flopteese] business and the bedding troughs. The prices that we get, our share of what they call in the UK the cash box is proportionately higher than it is in the [Flopteese] business. The reason why we’re able to do that, I think I explained this to you before is that in the old analog model there were actually three participants in the gaming machine system business the analog machine manufacturer, what they call the distributor who actually bought the machine from the manufacturer and leased it to the pub and provided the service and then the pub. In the digital model one of the benefits expect if you happened to have been a distributor is that the distributor is no longer necessary because the game is being distributed via the network electronically. In effect the margin that used to go to the distributor is able to be divided between us and the pub operator and consequently we can get a price that’s a higher percent of the net win and still leave the pub substantially better of then he is now. The net result of that is at least right now in both Games Media and Global Draw we have about the same target annual revenue to ourselves.

[Operator:]

Your last question comes from Carlo Santarelli - JP Morgan

[Carlo Santarelli:]

Can you comment and possibly quantify the impact from a stand along perspective of moving the printing from Alpharetta to China, how do you see that going and how quickly do you think margins will ramp and make up that 200 basis point delta you guys spoke about.

[Mike Chambrello:]

I think we’ll start to see some relief in Alpharetta at the end of the first quarter. I think we’ll start to see margin in China production begin to approach historical Alpharetta in the second half of this year. We’re sort of in a situation where Alpharetta will begin to come back to norms while China is ramping up so the margins in China will be lower than historical. Probably by the second half of the year they’ll be roughly equal.

[Carlo Santarelli:]

Could you guys comment on your ability and I guess the way the contracts are structured how you’re able to move or shift inventory if you are at all in China from say provinces that have sold out to provinces that have stale inventory?

[Lorne Weil:]

This was a new concept the squeaky wheel got the tickets during start up but it’s important to understand that each province purchases their tickets independently so it’s not like the central government is issuing or allocating tickets and the central government actually owns them, it’s province by province. We have had recently some better luck in transferring tickets from province ‘a’ to province ‘b’ in order to do a little game balancing but there certainly tickets for instance in the outlying provinces where the three RMB sells higher and we’d like to get some of the 10 RMB out of those provinces and into Beijing and Shandong and some of the other higher sellers. It’s a little bit difficult and cumbersome but it is beginning to happen. The very good news though is that the provinces are now learning what it is they sell best and the CSL and CSLT do recognize the importance of efficient inventory allocation and as we go into next year I think we’ll see less of a need to do a reallocation because the first or second distributions will be more effective.

[Carlo Santarelli:]

If you guys could provide some color on how you see printed products in the 4Q given the changes in Florida and maybe if there’s some color or guidance you can provide on that that would be helpful.

[Lorne Weil:]

I’ll give you my thought and then Mike can give you his. From a sequential point of view I think the big plus is moving from the seasonally weakest quarter in Italy to a seasonally very strong quarter so that will be a big plus both in terms of printed product shipments, printed product margins and our share of the consortium profit. The negative as Mike alluded to in the fourth quarter will be the kicking in of the new contract in Florida which is at a lower rate. We’ll have a counter veiling impact on profitability. I’m not sure as I sit here which of those two is greater. I would imagine that the pick up in Italy will be greater than the impact of Florida but at least part of that depends as Mike was saying on Florida getting its act together in terms of getting back on track with our sales. At the end of the day the question in terms of sequentially where would the fourth quarter be relative to the third is going to come down to how the sales everywhere else in the world maintain themselves and whether any material progress in this margin process that we’ve been talking about for the last hour or so. My own feeling is I don’t see that there is going to be very much of that until we’re funded and at least self sufficient in China. Then I would expect to see a step function increase in both the Chinese margin and the rest of the business coming out of Alpharetta.

[Mike Chambrello:]

We continue to plan for the transition in China from US based manufacturing to China based manufacturing we’re certainly going to continue to work very hard to build up inventory as we head to the end of the year that actually in China may not even be sold until 2009. That could keep some of our historical business either in a delay mode or pushed out a little bit. The lynch pin really is China, I agree with Lorne’s comments on Florida certainly. The more inventory we can get in place by the end of the year in China for the transition to self sufficiency in Q1 and Q2 that could impact business that would otherwise be done for our domestic or European customers.

[Operator:]

This concludes our question and answer session. I would now like to turn the call back over to Mr. Weil for closing remarks.

[Lorne Weil:]

Thank all of you for participating in the call this morning. I hope you’ve been able to read between the lines of what Mike and I have been saying that we are hugely upbeat about where the business is heading. The fourth quarter, as we’ve said is going to be a process of working through a number of the things we talked about before. If you model things out for where we should be as we get into the first and second quarter next year both in terms of our revenue trajectory and the margin situation it’s very positive and very exciting. We’re looking forward to talking to you around the end of February. Happy Thanksgiving, Halloween, Merry Christmas and New Year. We’ll talk to you in February.

[Operator:]

Thank you for your participation in today’s conference this concludes your presentation you may now disconnect. Good day everyone.