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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K


ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2003,

Or

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                to                                 

Commission file number: 0-13063


SCIENTIFIC GAMES CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation or organization)
  81-0422894
(I.R.S. Employer Identification No.)

750 Lexington Avenue, 25th Floor
New York, New York 10022

(Address of principal executive offices)

Registrant's telephone number:
(212) 754-2233

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Title of each class

 

Name of each exchange on which registered

Class A Common Stock, $.01 par value   Nasdaq National Market

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý    No o

        As of June 30, 2003 the market value of voting and non-voting common equity held by non-affiliates of the registrant was approximately $497,266,314.(1)

        Common shares outstanding as of March 12, 2003 were 62,398,287.


DOCUMENTS INCORPORATED BY REFERENCE

        The following document is incorporated herein by reference:

Document
  Parts Into Which Incorporated
Proxy Statement for the Company's 2004 Annual Meeting of Stockholders   Part III
(1)
For this purpose only, "non-affiliates" excludes directors and executive officers.

EXHIBIT INDEX APPEARS ON PAGE 124





PART I
FORWARD-LOOKING STATEMENTS

        Certain statements contained in this Form 10-K constitute "forward-looking statements" within the meaning of the United States Private Securities Litigation Reform Act of 1995. In some cases, forward-looking statements can be identified by the use of forward-looking terminology such as "may," "will," "estimate," "intend," "continue," "believe," "expect" or "anticipate" or the negatives thereof, variations thereon or similar terminology. The forward-looking statements contained in this Form 10-K are generally located in the material set forth under the headings "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business," but may be found in other locations as well. These forward-looking statements generally relate to plans and objectives for future operations and are based upon management's reasonable estimates of future results or trends. Although we believe that the plans and objectives reflected in or suggested by such forward-looking statements are reasonable, such plans or objectives may not be achieved. Actual results may differ from projected results due, but not limited, to unforeseen developments, including developments relating to the following:

        You should read this Form 10-K completely and with the understanding that actual future results may be materially different from what we expect. All subsequent written and oral forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the foregoing factors. These forward-looking statements speak only as of the date of the document in which they are made. We disclaim any obligation or undertaking to provide any updates or revisions to any forward-looking statement to reflect any change in our expectations or any change in events, conditions or circumstances in which the forward-looking statement is based.

        As you read this Form 10-K, you should also note the following: This Form 10-K contains various references to industry market data and certain industry forecasts. The industry market data and industry forecasts were obtained from publicly available information and industry publications. Industry publications generally state that the information contained therein has been obtained from sources believed to be reliable, but that the accuracy and completeness of that information is not guaranteed. Similarly, industry forecasts, while we believe them to be accurate, have not been independently verified by us and we do not make any representation as to the accuracy of that information.

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ITEM 1. BUSINESS

        Unless the context indicates otherwise, all references to "Scientific Games," "we," "our," "ours," "us" and "the Company" refer to Scientific Games Corporation and its consolidated subsidiaries. "International" refers to non-United States jurisdictions. "On-line" lottery refers to a computerized system in which lottery terminals in retail outlets are continuously connected to a central computer system for the sale and validation of lottery tickets and related functions. "OTB" refers to off-track betting facilities, including those owned and operated by our subsidiaries Autotote Enterprises, Inc. (in Connecticut) and Autotote Nederland B.V. (in The Netherlands). "Handle" is an industry term for dollars wagered.

Overview

        We are a leading worldwide provider of services, systems and products to both the instant ticket lottery industry and the pari-mutuel wagering industry based on revenues. We believe we offer our customers the widest array of some of the most technologically advanced products and services in each of these industries. We also believe that we are the world's only fully integrated lottery service provider, offering lottery authorities on-line lottery systems, instant tickets and related facilities management, or cooperative services, programs, which effectively enable such authorities to outsource all of their instant ticket lottery operations to us.

        We operate in four business segments: Lottery Group, Pari-mutuel Group, Venue Management Group and Telecommunications Products Group.

Lottery Group (65% of 2003 revenue)

        We are a leading worldwide provider of services, systems and products to the instant ticket lottery industry based on revenues. We believe that we are the world's only fully integrated lottery service provider, offering on-line lottery systems, instant tickets and related facilities management, or cooperative services, programs to lottery authorities.

        Our instant ticket and related services business is the industry leader in the United States, with approximately 65% of all retail sales. Our instant ticket customers include 28 of the 42 U.S. jurisdictions that currently sell instant lottery tickets, and we have sold instant tickets to lotteries in over 50 other countries. In addition to ticket design and manufacturing, we provide lotteries with related value-added services through our cooperative services program, including game design, sales and marketing support, inventory management and warehousing and fulfillment services. We also provide lotteries with licensed brand products, including Hasbro®, Mandalay Bay®, National Basketball Association ("NBA")®, Harley-Davidson® and Wheel-of-Fortune®, to name a few. Additionally, we provide lotteries with our probability-based instant lottery tickets, which utilize a patented electronic circuit printed in each ticket to produce a ticket with multiple possible outcomes, and probability ticket validation terminals based on our proprietary security technology. We believe that these innovative products will allow lotteries to increase retail sales of instant tickets. Our instant ticket contracts typically have an initial term of three years and frequently include multiple renewal options which our customers generally exercise for additional periods ranging from one to five years. We typically sell our instant tickets for a per unit price or are paid a fee equal to a percentage of the retail value of the instant tickets sold. Instant tickets and related services accounted for approximately 65% of the revenue of our Lottery Group in 2003.

        Our lottery systems business primarily provides sophisticated, customized computer software, equipment, and data communication services to lottery authorities for on-line and instant ticket games.

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In the U.S., we typically provide the necessary equipment, software and maintenance services pursuant to long-term contracts that typically have a minimum initial term of five years, under which we are generally paid a fee equal to a percentage of all dollars wagered on lottery tickets. Our U.S. systems contracts typically contain multiple renewal options that generally have been exercised by our customers. Internationally, we typically sell terminals and systems to lottery authorities outright and provide ongoing fee-based support under long-term contracts. We have contracts to operate on-line lottery systems for 16 of the 42 on-line lottery authorities in the U.S., and we believe we are the second largest on-line lottery provider in Europe.

Pari-mutuel Group (15% of 2003 revenue)

        We are a leading worldwide provider of computerized wagering systems to the pari-mutuel wagering industry. We provide our systems and services to horse and greyhound racetracks, OTBs, casinos, jai alai frontons, telephone and Internet account wagering operators and other establishments where pari-mutuel wagering is permitted. In addition, we are a leading provider of ancillary services to the industry, such as race simulcasting and telecommunications services, video gaming terminals and telephone and Internet account wagering.

        In 2003, our systems processed approximately 65% of the estimated $20 billion in pari-mutuel wagering conducted on racing in North America. Based on Handle, our customers include 10 of the 15 largest thoroughbred racetracks in North America and 10 of the 12 largest North American OTB networks. In our North American pari-mutuel business, we enter into service contracts, typically with an initial term of five years, pursuant to which we are paid a weighted average fee of approximately 0.32% of all wagers processed by our wagering systems, and we receive additional fees for our ancillary services, on either a per event or a monthly subscription basis. In most international markets, we sell our pari-mutuel wagering systems and terminals to pari-mutuel operators.

Venue Management Group (11% of 2003 revenue)

        We own and have the right to operate in perpetuity substantially all off-track pari-mutuel wagering in Connecticut, subject to our compliance with certain licensing requirements. Our Connecticut operations consist of 12 OTB facilities, including video simulcasting at two teletheaters and four other branches, and telephone account wagering for customers in 27 states. We also provide facilities management services to the Mohegan Sun Casino racebook in Connecticut. Our weighted average commission, based on Handle, for our Connecticut OTB operations is approximately 21.0%.

        We have the right to operate all on-track and off-track pari-mutuel wagering in The Netherlands under a license granted by the Dutch Ministry of Agriculture which extends through June 2005. We also received additional license approvals to allow us to modernize and expand pari-mutuel wagering in The Netherlands. These approvals allow us to open up to 20 teletheaters, increase the number of OTBs, expand into arcade shops, implement interactive account wagering, and expand national and international simulcasting of racing, including commingling with the V75 pools in Sweden. We currently operate 33 OTB locations throughout The Netherlands, including wagering in three Gaming Halls, and four on-track OTBs, as well as at five tracks. Our weighted average commission, based on Handle, for our Dutch operations is approximately 31.5%.

Telecommunications Products Group (9% of 2003 revenue)

        We are a leading manufacturer of prepaid phone cards in the world, which cards entitle cellular phone users to a defined value of airtime. Prepaid phone cards offer consumers worldwide a cost-effective way to purchase cellular airtime, without requiring phone companies to extend credit or consumers to commit to contracts.

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        Prepaid phone cards utilize the secure process employed by Scientific Games in the production of instant lottery tickets. This helps to ensure complete integrity and reliability of the product, thus providing consumers in more than 50 countries with access to cellular phone service. We have approximately 20% of the fragmented European market for prepaid cellular phone cards and we believe we are the largest supplier of paper-based prepaid phone cards in the world. Because card access number theft is common, the security of the card is critical; our phone cards incorporate proprietary security technology originally developed for our instant lottery ticket operations. Sales office locations now include Malaysia, Hong Kong, India, Nigeria, Ivory Coast, Turkey, Egypt and the Ukraine.

Industry Overview

Lottery Market

        Lotteries are operated by domestic and foreign governmental authorities and their licensees in approximately 200 jurisdictions throughout the world. Currently, 44 U.S. jurisdictions (including the District of Columbia, Puerto Rico, and the U.S. Virgin Islands) sell instant and/or on-line lottery tickets. Governments typically authorize lotteries as a means of generating revenues without the imposition of additional taxes. Net lottery proceeds are frequently set aside for particular public purposes, such as education, aid to the elderly, conservation, transportation and economic development. As proceeds derived from lottery ticket sales have become a significant source of funding for such programs, many jurisdictions have come to rely on such proceeds to support some of those public purposes.

        Although there are many types of lottery games worldwide, governmentally authorized lotteries may generally be categorized into three principal groups: instant lotteries, on-line lotteries and the traditional draw-type lotteries. An instant ticket lottery is typically played by removing a coating from a preprinted ticket to determine whether it is a winner. On-line lotteries, such as Powerball®, are based on a random selection of a series of numbers. On-line lottery prizes are generally based on the number of winners who share the prize pool, although fixed prizes are also offered. On-line lotteries are conducted through a computerized system in which lottery terminals in retail outlets are continuously connected to a central computer system. On-line lottery systems may also be used to validate instant tickets to confirm large prize levels and prevent duplicate payments, or separate instant ticket validation systems may be installed. Internationally, the older form of traditional draw-type lottery games, in which players purchase tickets which are manually processed for a future drawing for prizes of a fixed amount, is a popular form of play. In addition, lotteries may offer keno, video lottery, sports and other lottery games. Quick draw keno is typically played every five minutes in restricted social settings such as bars and is usually offered as an extension of on-line lottery systems. There are video lotteries played on video lottery terminals, or VLTs, featuring "line-up" and card games, typically targeted to locations such as horse and greyhound racetracks, bars, nightclubs and similar establishments. Video lotteries generally use a system different from an on-line system for accounting, security and control purposes. In addition, in Oregon, several provinces in Canada and several countries outside the U.S., lotteries offer pari-mutuel or fixed odds wagers on various sports.

        Instant ticket and on-line lottery retail sales comprised 93% of the U.S. market for lotteries in 2003. Based on industry information, 2003 U.S. on-line lottery retail sales totaled approximately $20.6 billion, and 2003 U.S. instant ticket lottery sales totaled approximately $21.7 billion. The U.S. instant ticket market grew at a compound annual growth rate of 7.46% from 1994 to 2003. Based on industry information, we estimate that 2003 international on-line lottery retail sales totaled approximately $79.0 billion and that 2003 international instant ticket lottery sales totaled approximately $35.0 billion. Industry data indicates that instant ticket retail sales have been growing faster than on-line games because of "instant" rewards rather than the delayed rewards of on-line games with periodic or weekly drawings.

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U.S. Instant Ticket and On-line Lottery Sales

GRAPHIC

Source: LaFleur's World Lottery Almanac

Pari-mutuel Market

        In pari-mutuel wagering, individuals bet against each other on horse races, greyhound races, jai alai matches and other events. Pari-mutuel wagering patrons place specific types of wagers (e.g., on a specified horse to win) and a patron's winnings are determined by dividing the total Handle wagered, less a set commission, among the winners. Wagering is generally conducted at horse and greyhound racetracks, jai alai frontons, OTBs and casino racebooks or through licensed telephone and Internet account wagering operators. Licenses to conduct races and/or offer pari-mutuel wagering are granted by governments to private enterprises, non-profit racing associations and occasionally government organizations, including lotteries.

        Pari-mutuel wagering is currently authorized in 43 states in the U.S., Puerto Rico, all provinces in Canada and approximately 65 other countries around the world. We estimate that total worldwide annual Handle in the pari-mutuel business is approximately $116.0 billion. Based on industry information, we estimate that the North American market for all forms of pari-mutuel wagering is approximately $20 billion.

        Remote wagering, in which customers bet on races held at another location, has caused substantial changes in the distribution channels for pari-mutuel wagering and consolidation of live racing. Wagering within the pari-mutuel industry has evolved from wagering only at a racetrack where a race is held, to wagering at a racetrack on races simulcast from other racetracks, to wagering at an OTB or other off-track venue, and now, in some jurisdictions, to wagering via the telephone and the Internet.

        In addition to favorable changes in the applicable statutes and regulations, a number of technological advances have facilitated remote wagering, including the simulcasting of live races via private satellite video networks, public broadcasting and Internet video streaming. Remote wagering has also increased Handle by enabling wagering on most racing events, facilitating virtually around the clock wagering, year-round. Increases in remote Handle have more than offset a decline in live Handle (i.e., Handle at the race or event itself). Remote wagering increased its share of the total U.S. thoroughbred pari-mutuel racing industry Handle from 15% in 1986 to 87.5% in 2003. The dollar

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volume of remote wagering in North America on thoroughbred racing has grown from $5.4 billion in 1993 to $13.3 billion in 2003, a compound annual growth rate of approximately 9.4%.


U.S. Thoroughbred Industry Pari-Mutuel Wagering: Remote and Live Handle

GRAPHIC

Source: Equibase Company LLC; The Jockey Club

        One of the most recent developments in remote wagering is account wagering, whereby a customer deposits money with a licensed account wagering operator and uses the account balance to fund wagers and receive winnings. This enables the customer to place wagers from locations remote to the licensed facility, including via telephone or the Internet. Patrons in most states where pari-mutuel wagering is allowed by law are able to place wagers through subscription-based account wagering operators. Subject in some jurisdictions to the adoption of the necessary enabling regulations, legislation explicitly permitting account wagering on pari-mutuel wagering has been passed in 15 U.S. states: California, Connecticut, Kentucky, Louisiana, Maryland, Massachusetts, Nevada, New Hampshire, New Jersey, New York, North Dakota, Ohio, Oregon, Pennsylvania and Wyoming. Such legislation has also been passed in Canada, the United Kingdom and other countries.

Prepaid Phone Cards Market

        Prepaid phone cards offer consumers convenient cellular airtime purchases and help to increase the market for cellular services. We believe that the further growth of cellular phone penetration will expand the prepaid phone card business. It is estimated that approximately 50% of all European cellular phone subscribers use prepaid calling services. While less common in the U.S., prepaid phone cards offer consumers worldwide a cost-effective way to purchase cellular airtime, without requiring phone companies to extend credit or consumers to commit to contracts. We have approximately 23% of the European market for prepaid cellular phone cards and are the largest supplier of paper-based prepaid phone cards in the world. Because card access number theft is common, the security of the card is critical; our phone cards incorporate proprietary security technology originally developed for our instant lottery ticket operations.

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Operational Overview

Lottery Group

        Our Lottery Group provides instant tickets and related services and lottery systems.

        Instant Ticket and Related Services.    In 1974, we introduced the first secure instant game ticket. Today, we remain a leading designer, manufacturer and distributor of instant tickets worldwide. We market instant tickets and related services to domestic lottery jurisdictions, foreign lottery jurisdictions and commercial customers. We presently have contracts with 28 of the 42 U.S. jurisdictions that currently sell instant lottery tickets. Our instant ticket contracts typically have an initial term of three years and frequently include multiple renewal options which our customers generally exercise for additional periods ranging from one to five years. We typically sell our instant tickets for a per unit price or are paid a fee equal to a percentage of the retail value of the instant tickets sold. In addition, we have sold instant lottery tickets to customers in over 50 countries internationally. In 2002 and 2003, we sold approximately 13.9 billion and 15.3 billion, respectively, 2 × 4 inch equivalent instant tickets, of which approximately 16% were sold outside the U.S. Some international customers purchase instant tickets as needed rather than through supply contracts.

        The instant tickets we manufacture are typically printed on recyclable ticket stock by a series of computer-controlled presses and ink-jet imagers, which we believe incorporate the most advanced technology and security currently available in the industry. Instant tickets generally range in size from 2 inches by 3 inches to ticket sizes as large as some calendars; instant tickets are normally played by removing a coating to determine if they are winning tickets.

        The increased application of computer-based and communications technologies to the manufacturing and servicing of instant tickets continues to separate the printing of instant ticket from conventional forms of printing. We are generally recognized within the lottery industry as the leader in applying these technologies to the manufacturing and sale of instant tickets. In order to maintain our position as a leading innovator within the lottery industry, we intend to continue to explore and develop new technologies and their applications to instant lottery tickets and systems. We also manufacture instant tickets for promotional games and sell pull-tab tickets to our lottery customers through a marketing agreement with International Gamco, Inc., a manufacturer of pull-tab lottery tickets.

        We pioneered the idea of privatizing lottery functions, through our cooperative services program, whereby we manage a lottery authority's instant ticket operations, as a means of reducing the operating costs of lottery authorities while increasing lottery revenues. We are the only instant ticket manufacturer to provide such complete facilities management and support services to supplement its manufacturing operations. Cooperative services contracts bundle instant tickets, systems, facilities management and/or other services, including the design and installation of game management software, telemarketing, field sales, accounting, instant ticket game design, inventory and distribution, sales staff training, managing staff, advising with respect to security, maintenance, communication network and sales agent hot-line service for lottery jurisdictions. While the majority of lottery jurisdictions to date have chosen to manage the distribution and sales of tickets themselves, we have been successful in demonstrating to a number of jurisdictions that we can perform these functions more effectively. We expect that more state or foreign governments will decide to privatize or outsource various lottery operations. We have significant experience in these services and are well-positioned to offer this privatization or outsourcing option to lottery authorities.

        We have contracts for cooperative services with the states of Arizona, Delaware, Florida, Georgia, Maine, Pennsylvania, South Carolina and Tennessee. Under such contracts, we are paid a percentage of the lottery authority's total instant ticket revenues. Customers designate the services they want us to perform from a menu of cooperative services offered. Once our cooperative services programs are in place, replacement of these contractual arrangements may require the lottery authority to incur large

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conversion costs to hire and/or retrain staff and redesign and install a software system and other protocols to manage its instant ticket business.

        In June 2002, we expanded our presence in Latin America with the purchase of a 65% equity interest in Serigrafica Chilena S.A., a leading supplier of lottery tickets, prepaid phone cards and promotional games in Latin America. This purchase has enabled us to expand our share of the Latin American market for both the instant ticket and the prepaid phone card businesses.

        In January 2003, we significantly expanded our offerings of licensed branded lottery products and prize fulfillment and related services with the acquisition of MDI Entertainment, Inc. ("MDI"). MDI has been successful in helping lotteries attract players to new kinds of tickets and second chance games that allow players to win merchandise, such as Harley-Davidson motorcycles and trips and prizes like tickets to NBA playoff games. Our portfolio of licensed brands now includes Hasbro, Mandalay Bay, NBA, Harley-Davidson and Wheel-of-Fortune, plus many others. The acquisition of MDI has enabled us to further expand the use of branded games and prize fulfillment services to continue to help our customers generate additional revenues.

        Lottery Systems.    We are a leading provider of sophisticated, customized computer software, equipment and data communication services to government-sponsored and privately-operated lotteries in the U.S. and internationally. This business includes the sale of on-line systems, instant ticket validation systems and terminals. Central computer systems, terminals and associated software are typically provided in the U.S. through facilities management contracts and internationally through outright sales, often from different vendors.

        Our lottery systems utilize proprietary technology that is similar to that used for pari-mutuel wagering, but is specialized for lottery operations. Our systems facilitate high speed processing of on-line wagers as well as validation of winning on-line and instant play tickets, including probability-based instant lottery tickets. Our lottery business includes the supply of transaction-processing software that accommodates instant ticket accounting and validation and on-line lottery games, point-of-sale terminal hardware which connects to these systems, central site computers and communication hardware which run these systems, and on-going operation support and maintenance services. We also provide software, hardware and support for sports betting systems and operation of credit card processing systems for non-lottery customers.

        On November 6, 2003, we acquired IGT OnLine Entertainment Systems, Inc. ("OES") from International Game Technology. OES operates on-line lottery systems in seven states and the Caribbean, and supports systems sold to customers in Korea, Norway, Switzerland and Shanghai. The acquisition also included OES's Advanced Games System (AGS) video system contracts in six jurisdictions throughout the world, certain intellectual property and an exclusive license to specific IGT slot brands for both instant and on-line games. Upon consummation of the acquisition, we changed the name of OES to Scientific Games Online Entertainment Systems, Inc.

        In the U.S., we provide on-line systems and services to, among others, the following state lotteries: Connecticut, Iowa, Maine, Montana, New Hampshire, South Carolina and Vermont. With the acquisition of OES in November 2003, we added the following state lotteries: Delaware, Florida, Indiana, Maryland, Pennsylvania, South Dakota and West Virginia. Contracts with North Dakota and Colorado will commence in March 2004 and November 2004, respectively. The contract with Florida terminates December 2004. Recent on-line lottery system procurements have requested the capability to support the secure validation of probability-based instant lottery tickets, and we have bid SciScan Technology® terminals both with our on-line systems and through other on-line system providers. SciScan Technology® is a keyless validation system for retailers which significantly reduces the time required for ticket validation, while at the same time improving the security of the game. SciScan Technology® terminals can be operated on a stand-alone basis or attached to an on-line lottery terminal to validate traditional instant tickets utilizing optical bar code technology, or our proprietary Winner's Choice™ probability-based instant lottery tickets.

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        Internationally, we have systems operating in France, The Netherlands, Switzerland, Austria, Australia, Canada, Jamaica, seven states in Germany, Peru and other countries, and we provide on-line system facilities management services to nationwide lotteries in Barbados and the Dominican Republic.

        We also sell our lottery terminals separately from our sale of complete lottery systems. Our terminal product offerings include the EXTREMA® on-line lottery terminals, SciScan Technology® terminals, STAN™ self-serve terminals and Play Central™ terminals. Our EXTREMA® on-line terminals utilize a standard PC architecture, graphical interface touch screens for teller input without a keyboard and high speed thermal printers.

        On November 11, 2003, we announced that a consortium consisting of the Company, Lottomatica S.p.A, and Arianna 2001, a company owned by the Federation of Italian Tobacconists, had signed a contract with the Italian Monopoli di Stato to be the exclusive operator of the Italian Gratta e Vinci instant lottery. The contract has an initial term of six years with a six year-extension option. Under the contract, we will provide and support application software, will be the exclusive supplier of instant tickets, will participate in the profits of the lottery operation as an equity partner, and will partner with Lottomatica in the overall management of the lottery. The contract was initially awarded in 2001, but the ratification of the award was delayed by a series of protests by competing bidders.

United States Lottery Contracts

        The table below lists the U.S. lottery contracts for which we had executed agreements as of March 1, 2004 and certain information with respect thereto. We are the exclusive provider of systems in all contracts and the primary supplier of instant tickets unless otherwise noted. The commencement date of the current contract is the date we began generating revenues under such contract, which for our on-line contracts is typically the start-up date. The table also includes instant ticket or on-line retail sales, as applicable, for each state or district.

State/District

  Fiscal 2003* State
Instant Ticket
or On-line
Retail Sales

  Type of
Contract**

  Commencement
Date of
Current Contract

  Expiration Date of
Current Contract
(before exercise
of remaining
renewal options)

  Current
Renewal
Options
Remaining

 
   
   
  (in millions)

   
   
Arizona   $ 159.2   ITRS   January 2003   January 2008   2 one-year
Colorado     254.3   ITRS   July 2000   June 2004   1 one-year
Colorado (3)     137.2   On-line   November 2004   October 2010   2 two-year
Connecticut     530.7   ITRS   August 2002   August 2004   3 one-year
Connecticut     334.7   On-line   May 1998   May 2008   none
Delaware     22.3   ITRS   November 2000   November 2005   none
Delaware     80.1   On-line & Video   September 2002   February 2010   5 one-year
District of Columbia     36.1   ITRS   December 2001   December 2004   2 one-year
Florida     1,126.4   ITRS   April 1997   September 2008   none
Florida     1,698.3   On-line   September 1999   January 2005   none
Georgia     1,486.2   ITRS   May 2003   September 2010   none
Illinois     697.9   ITRS   June 2002   June 2005   2 one-year
Indiana (2)     405.5   ITRS   January 2002   January 2006   2 one-year
Indiana     258.5   On-line   January 1999   August 2006   3 one-year
Iowa     74.3   On-line   July 2001   June 2008   3 one-year
Kentucky (2)     351.4   ITRS   September 2002   October 2005   4 one-year
Maine     39.7   On-line   July 2001   June 2007   2 two-year
Maine     124.9   ITRS   July 2001   June 2007   2 two-year
Maryland     1,006.5   On-line   December 1995   July 2006   none
Massachusetts     2,894.3   ITRS   August 1999   August 2004   none
Minnesota (1)     210.9   ITRS   February 2000   January 2005   none
Missouri     428.9   ITRS   April 2001   June 2005   1 two-year
Montana     24.6   On-line   March 1999   March 2006   none
                       

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New Hampshire     70.3   On-line   July 2000   June 2006   2 two-year
New Jersey (1)     901.2   ITRS   November 2001   October 2006   2 one-year
New Mexico     80.2   ITRS   March 2003   March 2007   3 one-year
New Mexico     NA   Video   December 1998   December 2004   3 one-year
New York (1)     2,412.0   ITRS   November 2001   November 2004   2 one-year
North Dakota (3)     NA   On-line   March 2004   March 2012   2 one-year
Ohio     1,077.8   ITRS   July 2001   June 2005   1 two-year
Oregon (1)     136.3   ITRS   June 1998   June 2004   none
Pennsylvania     796.6   ITRS   April 1997   April 2005   2 one-year
Pennsylvania     1,336.4   On-line   February 1998   December 2008   none
South Carolina     422.9   ITRS   October 2001   October 2004   2 one-year
South Carolina     299.5   On-line   January 2002   December 2007   1 one-year
South Dakota     13.3   ITRS   June 2000   June 2005   none
South Dakota     15.5   On-line & Video   March 1999   August 2006   3 one-year
Tennessee (3)     NA   ITRS   January 2004   April 2011   none
Texas     2,148.0   ITRS   September 2003   August 2004   none
Vermont     12.5   On-line   July 2000   June 2006   2 two-year
Virginia (1)     543.4   ITRS   May 2001   May 2004   4 one-year
Washington     241.9   ITRS   March 2000   March 2004   2 one-year
West Virginia     105.4   ITRS   June 2000   June 2004   1 one-year
West Virginia     86.6   On-line   November 1999   July 2005   2 one-year

(1)
Secondary instant ticket supplier.

(2)
Pull-tab sales are included within instant ticket sales.

(3)
New contract commencing in 2004.

*Fiscal 2003 is the year ended June 30, 2003

**ITRS = Instant ticket and related services

**Video = Video lottery service contract

Pari-mutuel Group

        We are a leading worldwide supplier of technologically advanced computerized wagering systems and related equipment. We also provide simulcasting and telecommunications services, video gaming terminals and telephone and Internet account wagering.

        North American Pari-mutuel Operations.    In 2003, our systems processed approximately 65% of the estimated $20 billion in pari-mutuel wagering conducted on racing in North America. Based on Handle, our customers include 10 of the 15 largest thoroughbred racetracks in North America and 10 of the 12 largest North American OTB networks. We typically provide, install and maintain the necessary pari-mutuel wagering systems and equipment for our North American pari-mutuel customers, and we also provide race simulcasting and telecommunications services, video gaming terminals, and telephone and Internet account wagering systems.

        The pari-mutuel wagering systems we provide in North America typically include the terminals or account wagering devices that accept wagers and issue the wagering tickets, the central processing unit that calculates the betting odds of a particular event and tabulates and accounts for the Handle, the display board that indicates the betting odds of a particular event and the communication equipment necessary for additional wagering from sources outside the wagering facility. These systems utilize high volume, real-time transaction and data processing networks managed by central computers, communications equipment, special purpose microcomputer-based terminals, peripheral and display equipment and operations and applications software. The type of central processing unit and the

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number of ticket-issuing terminals used in a system are generally determined by the physical layout and amount of wagering at each facility. We also provide additional software and other support functions.

        We have continued to focus on the creation of regional networks of large and medium sized racetracks and OTB networks, rather than single facilities at smaller racetracks. Our networks link multiple racetracks, OTBs, and regional networks of racetracks and OTBs to one another via dedicated, secure, high-speed communications channels, enabling operators to capitalize on the growth of the off-track wagering market in a more cost-effective manner. Additionally, when linked to our other regional and national pari-mutuel wagering networks, these networks provide our customers with access to new markets and revenue sources by increasing the number and variety of wagering opportunities that customers can offer to their patrons. We believe our established wagering networks will give us a competitive advantage in renewing existing contracts and winning new contracts in regions where such networks exist because of our ability to offer customers greater services more efficiently than our competitors. In North America, we currently operate regional pari-mutuel wagering networks in California, Connecticut, Florida, Illinois, New Jersey, New York, Oregon, Pennsylvania, Texas, Washington, West Virginia, Puerto Rico, British Columbia and Ontario.

        Our pari-mutuel wagering system contracts typically have an initial term of five years, and we have generally been successful in renewing these contracts. Our contracts contain certain warranties regarding implementation, operation, performance and reliability of our wagering systems relating to, among other things, data accuracy, repairs and validation procedures. The terms of our warranties vary from contract to contract. We also provide the operations, maintenance and supervisory personnel necessary to operate the pari-mutuel wagering system. We maintain ownership of the pari-mutuel wagering systems, which enables us to employ such equipment in more than one racetrack at different times during the year as most customers do not operate live wagering all year long.

        We typically receive revenue for our services in North America as a varying percentage of Handle, generally ranging up to approximately 0.55% of the Handle on a particular event (with a weighted average of approximately 0.32% of the Handle), subject, in many instances, to minimum fees which are usually exceeded under normal operating conditions. Minimum fees under our service contracts are generally based on the number of days the facility operates, as well as other factors, including the type of system and number of terminals installed at the facility. In addition to the Handle-based fees and minimums, fees for extra equipment and services may be charged, particularly for new terminal models and equipment levels which exceed those originally contracted.

        In addition, we may also receive an "interface fee" of 0.125% or 0.15% of Handle for combining wagers into the "combined pools" of host tracks whose systems we operate, depending on whether we or another vendor provides such wagering services. We hold contracts with most of the U.S.'s premier thoroughbred venues that typically attract the greatest levels of simulcast and remote wagering, and therefore generate the highest interface revenues.

        International Pari-mutuel Operations.    In most international markets, we sell our pari-mutuel wagering systems and terminals to pari-mutuel operators; in other international markets, we provide pari-mutuel services similar to those provided by our pari-mutuel operations in North America. We provide and operate pari-mutuel wagering systems at all of the racetracks in Germany, Ireland, Turkey and Austria, as well as all of the OTBs in Germany, and in January 2003 we were awarded the contract to provide pari-mutuel services to S-TWK, the Poland racing organization. Our international pari-mutuel wagering systems are comparable to those deployed in North America and include computer software, ticket terminals, a central processing unit, display boards and communication equipment. These services are provided under long-term contracts of five to 10 years. We have generally been successful in renewing these contracts.

        In Germany, we provide pari-mutuel wagering systems and simulcasting services to the 9 major harness racetracks, the 16 major thoroughbred racetracks, approximately 50 OTBs and approximately 120 bookmaker shops. In Ireland, we provide ongoing maintenance and operating services through 2008 to Tote Ireland Ltd., a wholly-owned subsidiary of the Irish Horseracing Authority. In Turkey, we have

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provided a pari-mutuel system and associated maintenance services to the Turkey Jockey Club since 1995. In 2001, we completed the installation of 1,700 terminals and an ECLIPSE™ software conversion at the Turkey Jockey Club's six racetracks and 1,500 off-track betting agencies.

        In most international markets, we sell, deliver and install pari-mutuel wagering systems in racetracks and OTBs rather than operating them pursuant to service contracts. We have systems operating in approximately 24 countries. Each of these systems is customized to meet the unique needs of our customers, including game designs, regulatory requirements, language preferences, network communication standards and other key elements. The sale of a pari-mutuel wagering system includes a license for use of our proprietary system software as well as installation, training, technical assistance, support, accessories and limited spare parts.

        Simulcasting.    We are one of the leading providers of simulcasts of live horse and greyhound racing and jai alai matches to racetracks, OTBs, jai alai frontons and casinos in North America and Europe. We simulcast racing events from over 60 racetracks and jai alai frontons to more than 150 racetracks and almost 1,300 OTBs throughout North America. We provide similar services in Europe, particularly in The Netherlands and Germany, where we service all 30 racetracks and more than 200 OTBs and bookmaker shops.

        Simulcasting of races entails the encryption and transmission of an audio/video signal from one of our uplink trucks located at a racetrack to one of five satellite transponders we lease pursuant to long-term contracts, and the retransmission of this signal to other racetracks, OTBs and casinos, where the race signal is received and decoded for viewing. In general, we receive a daily event fee from the racetracks for up-linking the video and audio signals and a monthly fee from racetracks, OTBs and casinos for the use of our decoders.

        Our encryption/transmission equipment compresses each audio/video signal so that multiple signals can be transmitted via one satellite transponder. This technology maximizes the transmission capacity of each of our transponders. Any capacity that we do not use for our simulcasting contracts represents excess time that we may sell to other users of satellite communications, generally for short periods, but, from time to time, under long-term contracts.

        NASRIN®. In conjunction with our 70% interest in a joint venture with Churchill Downs, Inc., we operate a national voice/data telecommunications network, known as the North American Simulcast Racing Information Network, or NASRIN®, that serves almost 150 racetracks and OTBs. Built around AT&T's international frame relay network, NASRIN® securely transmits betting data at a fraction of the cost previously paid by the racetracks and other facilities, allowing racetracks and OTBs to expand their simulcast wagering opportunities. The system is designed to link all wagering locations in North America and to serve as a platform for future technology developments. In exchange for our services, we are paid certain fees based on bandwidth and level of service.

        Video Gaming Machines.    We have developed a proprietary line of progressive video gaming machines for use at racetracks in North America. They combine full gaming functionality, such as video poker, blackjack, simulated spinning reels and keno, with full race wagering functionality, including picture-in-picture capabilities. As a result, our video gaming machines allow patrons to wager on horse races and watch simulcasted races or other televised programs on a picture-in-picture video window, while continuing to wager on selected video games. We typically collect a flat fee per terminal plus fees for software upgrades and maintenance.

Venue Management Group

        We own and have the right to operate in perpetuity substantially all off-track pari-mutuel wagering in Connecticut, subject to our compliance with certain licensing requirements. Our Connecticut operations consist of 12 OTB facilities, including video simulcasting at two teletheaters and four other branches, and telephone account wagering for customers in 27 states. We are also the exclusive licensed

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operator for all pari-mutuel wagering in The Netherlands, with five racetracks and 33 OTBs under a contract continuing through June 2005. Our revenues are based on a weighted average percentage of the Handle wagered at our OTB venues, which ranges from 21% to 32%. We also provide facilities management services to the Mohegan Sun Casino racebook in Connecticut.

        In Connecticut, approximately $224 million was wagered in fiscal 2003 on more than 60 U.S.-based thoroughbred, harness and greyhound racetracks and jai alai frontons at or through our facilities. Since we commenced operations in 1993, we have implemented several important product and service enhancements, including expanded simulcasting from across the country, common-pool wagering, seven day per week operations at nine locations and expanded telephone wagering. Our revenues are based on an allowed percentage of Handle wagered through the Connecticut OTB. The percentage of the total Handle, or commission, which we may receive is determined by the track where the event is held and varies by type of wager. Our weighted average commission, based on Handle, for our Connecticut operations is approximately 21%. We also provide an extension of our OTB services, including pari-mutuel wagering and simulcasting services, to the Mohegan Tribal Gaming Authority for its racebook located at the Mohegan Sun Casino in Uncasville, Connecticut under a seven-year agreement. We believe this racebook is a state-of-the-art facility which incorporates the latest wagering technology and the most advanced audio and video simulcasting signals.

        We have the right to operate all on-track and off-track pari-mutuel wagering in The Netherlands under a license granted by the Dutch Ministry of Agriculture which extends through June 30, 2005. We also possess additional license approvals to allow us to modernize and expand pari-mutuel wagering in The Netherlands. These approvals allow us to open up to 20 teletheaters, increase the number of OTBs, expand into arcade shops, implement interactive account wagering, and expand national and international simulcasting of racing, including commingling with the V75 pools in Sweden. We currently operate 33 OTB locations throughout The Netherlands, including wagering in three Gaming Halls, and four on-track OTBs, as well as at five tracks. Our weighted average commission, based on Handle, for our Dutch operations is approximately 31.5%.

Telecommunications Products Group

        We are a leading manufacturer of prepaid phone cards in Europe, which entitle cellular phone users to a defined value of airtime. Prepaid phone cards offer consumers worldwide a cost-effective way to purchase cellular airtime, without requiring phone companies to extend credit or consumers to commit to contracts. We have approximately 20% of the fragmented European market for prepaid cellular phone cards and we believe we are the largest supplier of paper-based prepaid phone cards in the world. To prevent fraud, our phone cards incorporate proprietary security technology originally developed for our lottery ticket operations. We expect to participate in the anticipated continued growth in the cellular market. We sell our prepaid phone cards to phone companies for a per unit price.

        For additional information concerning our business and geographic segments, see Note 18 to the Consolidated Financial Statements.

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Contract Procurement

Lottery Group

        Government operated lotteries in the U.S. typically operate under state mandated public procurement regulations. See "Government Regulation". Lotteries select an instant ticket or on-line supplier by issuing a Request for Proposal, or RFP, which outlines contractual obligations as well as products and services to be delivered. An evaluation committee frequently comprised of key lottery staff evaluates responses based on various criteria. These criteria usually include quality of product, security plan and features, experience in the industry, quality of personnel and services to be delivered and price. We believe that our product functionality, the quality of our personnel, our technical expertise and our manufacturing efficiency give us many advantages relative to the competition when responding to state lottery RFPs. However, many lotteries still award the contract to the qualified vendor with the lowest price, regardless of factors other than price. Contract awards by lottery authorities are sometimes challenged by unsuccessful competitors, which can result in protracted legal proceedings. Internationally, lottery authorities do not always utilize such a formal bidding process, but rather negotiate with one or more potential vendors.

        U.S. instant ticket lottery contracts typically have an initial term of three years and frequently include multiple renewal options, which our customers have generally exercised for additional periods ranging from one to five years. Our U.S. on-line lottery contracts typically have a minimum initial term of five years, with additional renewal options. The length of these lottery contracts, together with their renewal options, limits the number of contracts available for bidding in any given year.

Pari-mutuel Group

        Contract awards by owners of horse and greyhound racetracks, OTBs and casinos and jai alai frontons, and from state and foreign governments, often involve a lengthy competitive bid process, spanning from specification development to contract negotiation and award. In recent years, there has been continued consolidation of racetrack ownership, which may increase the competitive nature of the contract procurement process. Our contracts for the provision of pari-mutuel systems services in North America are typically for terms of five years. In addition, our ancillary pari-mutuel services, such as simulcasting, are typically provided under one-year contracts. Historically, we have been successful in renewing our largest pari-mutuel contracts as they have come due for renewal.

Venue Management Group

        Our license to provide on-track and off-track services in The Netherlands expires in the year 2005. New venue management opportunities generally occur via the privatization of existing government operated OTBs, as in the cases of Connecticut and The Netherlands, the acquisition or outsourcing of an existing private racetrack or OTB operations, or new legislation or regulation enabling new distribution channels. These opportunities occur infrequently and may be subject to public procurement bidding requirements.

Telecommunications Products Group

        All telecommunications products customers issue purchase orders with agreed upon terms and conditions. In addition, certain customer purchase orders contain multiple delivery dates.

Research and Product Development

        We believe that our ability to attract new lottery and wagering system customers and retain existing customers depends in part on our ability to continue to incorporate technological advances into, and to improve, our products, systems and related equipment. We maintain a development program directed

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toward systems development as well as toward the improvement and refinement of our present products and the expansion of their uses and applications. Many of our product developments and innovations have quickly become industry standards.

Intellectual Property

        We have a number of U.S. and foreign patents that we consider, in the aggregate, to be of material importance to our business. Patents extend for varying periods of time according to the date of patent filing or grant and the legal term of patents in the various countries where patent protection is obtained. In the U.S., the term of a patent expires 20 years from the date of filing. The actual protection afforded by a patent, which can vary from country to country, depends upon the type of patent, the scope of its coverage and the availability of legal remedies in the country.

        Certain technology material to our lottery and pari-mutuel wagering products, processes and systems is the subject of patents issued, and patent applications currently pending, in the U.S. and certain other countries. In our lottery business, we utilize our patented and patent-pending technology for the production, secure printing, validation and distribution of instant lottery tickets. In our pari-mutuel business, our patent-pending systems and methods provide racing and wagering data and related information. None of our material patents is scheduled to expire until August 2006, and most of our material patents are not scheduled to expire until 2013 or later.

        We also have a number of U.S. and foreign registered trademarks and other common law trademark rights for certain of our products, including Winner's Choice™, Play Central™, Terra 2000®, SciScan Technology®, Aegis™, PROBE®, EXTREMA®, SGI-NET™, ECLIPSE™, NASRIN®, SAM®, STAN™, MAX®, TINY TIM®, On the Wire®, Autotote.com™ and others. Trademark protection continues in some countries, including the U.S., for as long as the mark is used and in other countries for as long as it is registered. Registrations generally are for fixed, but renewable, terms.

        In our lottery business, we have entered into a product development agreement pursuant to which we have an exclusive license to use certain third-party patented technology in our SciScan Technology® terminals. Subject to clauses providing for early termination, the agreement is scheduled to remain in effect until 2017. In our pari-mutuel business, we have a perpetual license to use certain software to monitor our simulcast systems, and a consortium of which we are a party has a license, scheduled to expire in 2021, to use certain software that supplies the database and various interfaces for our TrackPlay™ Internet and interactive television-based wagering platform. None of our licenses is material to our business as a whole. The software and control systems for our wagering systems are also the subject of copyright and/or trade secret laws.

        We are not aware of any pending claims of infringement regarding our patents, trademarks or other intellectual property in any of our current businesses.

Seasonality

        The first and fourth quarters of the calendar year traditionally comprise the weakest seasons for our pari-mutuel wagering businesses. As a result of inclement weather during the winter months, a number of racetracks do not operate and those that do operate often experience missed racing days. This adversely affects the amounts wagered and our corresponding service revenues. Wagering equipment sales and software license revenues usually reflect a limited number of large transactions, which do not recur on an annual basis. Consequently, revenues and operating results can vary substantially from period to period as a result of the timing of revenue recognition for major equipment sales and software license revenue. In addition, instant ticket and prepaid phone card sales may vary depending on the season and timing of contract awards, changes in customer budgets, ticket inventory levels, lottery retail sales and general economic conditions.

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Production Processes; Sources and Availability of Components

        Our dedicated computer-controlled printing process is specifically designed for producing secure instant lottery game tickets for governmentally sanctioned lotteries and promotional games as well as prepaid phone cards. Our facilities are designed for efficient, secure production of instant game tickets and support high-speed variable image printing, packaging and storage of instant game tickets. Instant ticket games are delivered finished and ready for distribution by the lottery authority, or by us in the jurisdictions which are part of an instant ticket contract with cooperative services. Paper and ink are the principal raw materials consumed in our ticket manufacturing operations. We have a variety of sources for both paper and ink and should, therefore, not be dependent on any particular supplier.

        Production of our lottery and pari-mutuel wagering systems and related component products primarily involves the assembly of electronic components into more complex systems and products. We produce our terminal products primarily at our manufacturing facility in Ballymahon, Ireland, or on a limited basis at our Georgia development facility. Other manufacturing may be contracted out to third party vendors, as needed.

        We normally have sufficient lead-time between reaching an agreement to provide a lottery or pari-mutuel wagering system and the commencement of operations so that we are able to provide the customer with a fully functioning system, customized to meet its requirements. In the event that current suppliers of central processing units were no longer available, we believe we would be able to adapt our application software to run on the then-available hardware in time to allow us to meet new contractual obligations, although the price competitiveness of our products might change. The lead-time for obtaining most of the electronic components we use is approximately 90 days. We believe that this is consistent with our competitors' lead-times and is also consistent with the needs of our customers.

Competition

Lottery Group

        The instant ticket and on-line lottery business is highly competitive, and our business faces competition from a number of domestic and foreign instant ticket manufacturers, on-line lottery system providers and other competitors, some of whom have substantially greater financial resources than we do. Our business continues to operate in a period of intense price-based competition. The award of contracts by state officials is influenced by factors including price, the ability to optimize lottery revenues through game design, technical capability, marketing capability and applications, the quality, dependability and upgrade capability of the network, production capacity, the security and integrity of the vendor's production operations, the experience, financial condition and reputation of the vendor and the satisfaction of other requirements and qualifications that lottery authorities may impose. Contract awards by lottery authorities are sometimes challenged by unsuccessful competitors, which can result in protracted legal proceedings that can result in delayed implementation or cancellation of the award.

        We currently have three instant lottery ticket competitors in the U.S.: Pollard Banknote Limited, or Pollard, Oberthur Gaming Technologies, or OGT, a subsidiary of Group Francois-Charles Oberthur of France, and Creative Games International, Inc., a subsidiary of Canadian Bank Note Company, Ltd. We estimate that the retail sales value of our U.S. customer base was approximately 65% of total U.S. instant ticket retail sales in 2003. Except as permitted by the applicable provisions of the North American Free Trade Act with respect to Canada and Mexico, it is currently illegal to import lottery tickets into the U.S. from a foreign country. Our business could be adversely affected should additional foreign competitors in Canada or Mexico export their lottery products to the U.S. or should other foreign competitors establish printing facilities in the U.S., Canada or Mexico to supply the U.S. market. Internationally, there are many lottery instant ticket vendors which compete with us including, among others, Pollard, OGT, Creative Games and GPS Honsel.

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        Our principal competitors in the U.S. on-line lottery systems business are GTech Corporation (with approximately 72% of the U.S. market based on retail sales) and Interlott Technologies, Inc. GTech is also our major competitor in the international on-line market with the balance of the market being served by Interlott Technologies, Inc., EssNet AB, International Lottery and Totalizator Systems, Inc. and a few other companies.

Pari-mutuel Group

        Our pari-mutuel operations face significant competition from other operators in the pari-mutuel business, other gaming venues such as casinos and state sponsored lotteries and other forms of legal and illegal gaming. We compete primarily on the basis of the design, performance, reliability and pricing of our products as well as customer service. To effectively compete, we expect to make continued investments in product development and/or acquisitions of technology.

        Our two principal competitors in the North American pari-mutuel wagering systems business are AmTote International, Inc. and United Tote Company. Our competition outside of North America is more fragmented, with competition being provided by several international and regional companies. In addition, we believe we are one of the leading providers in North America of video and data simulcasting services in this highly-fragmented industry. Current and future competitors in Internet-based wagering include YouBet.com and TVG.

Venue Management Group

        Our venue management business competes with other pari-mutuel operations as well as other forms of gaming and other entertainment. Competition for wagers comes from casinos, racetracks, lotteries and other forms of legal and illegal gambling. Other gaming competitors operate in our licensed markets and in surrounding areas and compete for our customers, and additional competitors could be licensed, or existing regulations could be changed, so as to adversely affect our competitive position.

Telecommunications Products Group

        The market for prepaid phone cards is highly fragmented, but competition comes from other instant ticket lottery printers utilizing lottery security and printing technologies, as well as alternative printing and non-printing technologies. Our telecommunications products operations compete with other printing companies on the basis of price, availability, product features and product security. There is competition within our class of products and other technologies to provide the desired functionality. There are alternative technologies such as smart cards or alternative means to provide the funding of telephone services. We have invested in new higher speed and higher capacity printing and packaging technologies that we believe, in combination with our lottery security and logistics expertise, will continue to provide us a competitive advantage in this market. Our competitors in this area include OGT, Schlumberger Limited and Gemplus S.A.

Security

        Attempts to penetrate security measures may come from various combinations of customers, retailers, vendors, employees and others. We constantly assess the adequacy of our security systems to protect against any material loss to any of our customers.

        Notwithstanding the foregoing, our wholly owned pari-mutuel wagering subsidiary, Autotote Systems, Inc. experienced a breach of security by an employee who altered betting data on previously placed wagering tickets—the $3 million "winning" wager on the races constituting the Pick Six at the Breeders' Cup at Arlington Park in Illinois on October 26, 2002, as well as two other multiple-race

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wagers from earlier in the month. The employee also engaged in a scheme whereby he used his authorized access to duplicate uncashed winning tickets.

        During our review of the Breeders' Cup Pick Six wager, we discovered evidence of the employee's wrongdoing before any financial loss to bettors occurred and immediately terminated the employee.

        Following the Breeders' Cup incident, we and the other industry totalizator companies agreed to industry-wide security improvements, including the installation of software necessary to scan all wagering pools in connection with multi-race wagers after each race of a multi-race wager. We have completed the installation of that software. We and the other totalizator companies also agreed to permit an audit of our respective computer security and procedures by Ernst & Young. We also engaged Kroll, Inc., a leading worldwide risk mitigation and security company, to conduct a separate review of our physical security, operational controls, hiring practices and internal compliance. In addition, we have independently committed to, and have begun, the deployment of a new control system to operate every one of our totalizator systems. This independent system runs in parallel with our computers, records data in real time and allows for a review by a third party of all data against the live system.

        On August 16, 2003, the National Thoroughbred Racing Association's Wagering Technology Working Group and Giuliani Partners jointly issued a report that stated that the unlawful activities of our former employee appeared to be an isolated event and that the additional security measures put into place after the Breeders' Cup incident have been effective means for improving wagering security and providing deterrence against similar types of crime.

        On December 9, 2003, we announced that we established a cooperative working relationship with The Jockey Club intended to seek to improve the capabilities and technology of the pari-mutuel industry's wagering systems and to provide the pari-mutuel industry with a more secure wagering infrastructure. We expect that the new system will be able, among other things, to transmit wagering transaction detail in real time to any independent, industry-owned central database for real-time security monitoring and industry-wide information management.

        In 2002, we incurred approximately $1.1 million of costs related to the former employee's malfeasance in connection with the Breeders' Cup incident. Although we believe that any future losses, if any, that may arise from this matter will not result in a material adverse effect on our consolidated financial position or results of operations, it is not feasible to predict with certainty, and there can be no assurance that our business might not be materially affected or that other security breaches will not occur.

        In our lottery business, we employ numerous security safeguards, including bar coding and providing additional layers of protection in our instant tickets. We have effected security measures in the areas of ticket specifications, production, packaging, delivery, distribution and accounting. We also incorporate computer function safeguards, including secure ticket data, control number encryption, winner file data, and ticket stock control, in our data processing and in the computer operations phase. In addition, we also retain a major public accounting firm to perform agreed upon security procedures for each game produced before it is sent to the customer.

        As the incidence and severity of publicly reported cases of physical and computer crime continue, major lotteries periodically reassess key security questions concerning the vulnerability of lottery games. Although we have not uncovered any practical, economically feasible way to breach the security of our instant tickets or on-line lottery games that could result in a material loss to any of our customers, no assurances can be given that security breaches will not occur.

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Employees

        As of December 31, 2003, we employed approximately 3,430 persons. Most of our U.S. pari-mutuel employees involved in field operations are represented by the International Brotherhood of Electrical Workers under contract, extending through October 2005. Most of our Canadian pari-mutuel employees are represented by the Service Employees International Union. Our lottery employee groups are represented by two labor unions: our employees in Austria are represented by a Worker's Council, which is typical of many European companies; and at the United Kingdom facility, approximately 360 employees are members of the Graphic Paper and Media Union.

Government Regulation

General

        Lotteries, pari-mutuel wagering, sports wagering, and video gaming may be lawfully conducted only in jurisdictions that have enacted enabling legislation. In jurisdictions that currently permit various wagering activities, regulation is extensive and evolving but customarily includes some form of licensing of a license applicant and its subsidiaries. Regulators in those jurisdictions review many facets of an applicant for or holder of a license including, among other items, financial stability, integrity and business experience. We believe we are currently in substantial compliance with all regulatory requirements in the jurisdictions where we operate. Any failure to receive a material license or the loss of a material license that we currently hold could have a material adverse effect on our overall operations and financial condition.

        In December 2000, Congress enacted legislation authorizing patrons to place pari-mutuel wagers, where lawful in each state involved, by "telephone or other electronic media" with off track betting systems in the same or different state. Regulatory authorities continue to review and interpret this legislation, which amended the federal Interstate Horseracing Act of 1978. New legislation may be enacted that would impose other restrictions on telephone and Internet wagering operations, and we are unable to predict whether such interpretations or legislation, if any, would have a material adverse impact on us.

        While we believe that our current and planned business activities comply with all applicable laws, law enforcement authorities in certain jurisdictions have opposed the expansion of wagering via telephone and the Internet. We cannot assure you that our activities or the activities of our customers will not become the subject of any law enforcement proceeding or that such proceeding, if any, would not have a material adverse impact on us or our business plans. Additionally, although we believe that the December 2000 amendment to the federal Interstate Horseracing Act of 1978 clarifies that account wagering, off-track betting and inter-track simulcasting, as currently conducted by the U.S. horse racing industry, are authorized under U.S. federal law, the amendment may not be interpreted in this manner by all concerned. We cannot assure you that we can continue to conduct our pari-mutuel, account wagering, OTB and race simulcasting operations in all of the jurisdictions in which we currently operate or that a discontinuation of any of these operations would not have a material adverse impact on us or our business plans.

        We have developed and implemented an extensive internal compliance program in an effort to ensure that we comply with legal requirements imposed in connection with our wagering-related activities, as well as legal requirements generally applicable to all publicly traded corporations. The compliance program is run on a day-to-day basis by a full-time compliance officer and is overseen by the Compliance Committee authorized by our Board of Directors. While we are firmly committed to full compliance with all applicable laws, there can be no assurance that such steps will prevent the violation of one or more laws or regulations, or that a violation by us or an employee will not result in the imposition of a monetary fine or suspension or revocation of one or more of our licenses.

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Lottery Operations

        At the present time, 44 U.S. jurisdictions (including the District of Columbia, Puerto Rico and the U.S. Virgin Islands), all the Canadian provinces, Mexico and many other foreign countries authorize lotteries. Lottery contracts and ongoing operations of lotteries both domestically and abroad are subject to extensive regulation. Although certain of the features of a lottery, such as the percentage of gross revenues that must be paid back to players in prize money, are usually fixed by legislation, the various lottery regulatory authorities generally exercise significant discretion, including the determination of the types of games played, the price of each wager, the manner in which the lottery is marketed and the selection of the vendors of equipment and services and retailers of lottery products. Furthermore, laws and regulations applicable to lotteries in the U.S. and foreign jurisdictions are subject to change, and the effect of such changes on our ongoing and potential operations cannot be predicted with certainty.

        To ensure the integrity of the contract award and wagering process, most jurisdictions require detailed background disclosure on a continuous basis from, and conduct background investigations of, the vendor, its subsidiaries and affiliates and its principal shareholders. Background investigations of the vendor's employees who will be directly responsible for the operation of the system are also generally conducted, and most states reserve the right to require the removal of employees whom they deem to be unsuitable or whose presence they believe may adversely affect the operational security or integrity of the lottery. Certain jurisdictions also require extensive personal and financial disclosure and background checks from persons and entities beneficially owning a specified percentage (typically five percent or more) of a vendor's securities. The failure of beneficial owners of our securities to submit to background checks and provide such disclosure could result in the imposition of penalties upon these beneficial owners and could jeopardize the award of a lottery contract to us or provide grounds for termination of an existing lottery contract.

        From time to time we retain governmental affairs representatives in various states of the U.S. to advise legislators and the public concerning our views on lottery legislation, to monitor such legislation and to advise us in our relations with lottery authorities. We also make campaign contributions to various state political parties and state political candidates. We believe we have complied with applicable laws and regulations concerning campaign contributions and lobbying disclosures.

        The award of lottery contracts and ongoing operations of lotteries in international jurisdictions also are extensively regulated, although this regulation usually varies from that prevailing in the U.S. Restrictions are frequently imposed on foreign corporations seeking to do business in such jurisdictions and, as a consequence, we have, in a number of instances, allied ourselves with local companies when seeking foreign lottery contracts. Laws and regulations applicable to lotteries in the U.S. and foreign jurisdictions are subject to change, and the effect of such changes on our ongoing and potential operations cannot be predicted with certainty.

Pari-mutuel Wagering

        At present, 43 states in the U.S., Puerto Rico, all of the Canadian provinces, Mexico and many other foreign countries have authorized pari-mutuel wagering on horse races, and 16 states and many foreign countries, including Mexico, conduct pari-mutuel wagering on greyhound races. In addition, Connecticut, Rhode Island, Florida and Mexico also allow pari-mutuel wagering on jai alai matches.

        Companies that manufacture, distribute and operate pari-mutuel wagering systems in these jurisdictions are subject to the regulations of the applicable regulatory authorities there. These authorities generally require a company, as well as its directors, officers, certain employees and holders of 5% or more of the company's common stock, to obtain various licenses, permits and approvals. Regulatory authorities may also conduct background investigations of the company and its key personnel and stockholders in order to ensure the integrity of the wagering system. These authorities have the power to refuse, revoke or restrict a license for any cause they deem reasonable. The loss of a

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license in one jurisdiction may cause the company's licensing status to come under review in other jurisdictions as well.

        In order for any of our subsidiaries to provide pari-mutuel wagering equipment and/or services to certain casinos located in Atlantic City, New Jersey, it must be licensed by the New Jersey Casino Control Commission, or the Casino Commission, as a gaming related casino service industry in accordance with the New Jersey Casino Control Act, or the Casino Control Act, and by the New Jersey Racing Commission. An applicant for a gaming related casino service industry license is required to establish, by clear and convincing evidence, financial stability, integrity and responsibility; good character, honesty and integrity; and sufficient business ability and experience to conduct a successful operation. We must also qualify under the standards of the Casino Control Act. We and any of our applicant subsidiaries may also be required to produce such information, documentation and assurances as required by the regulators to establish the integrity of all our directors, officers and financial backers, who may be required to seek qualification or waiver of qualification. For affiliates of New Jersey casinos, the Casino Commission traditionally has waived the qualification requirement for investors holding less than 15% of a debt issue. For institutional investors, the Casino Commission traditionally has waived the qualification requirement for holders if their positions are not more than 20% of the issuer's overall debt and not more than 50% of the specific debt issue.

        The Casino Commission has broad discretion in licensing matters and may at any time condition a license or suspend or revoke a license or impose fines upon a finding of disqualification or non-compliance. The Casino Commission may require that persons holding five percent or more of our Class A common stock qualify under the Casino Control Act. Under the Casino Control Act, a security holder is reputably presumed to control a publicly traded corporation if the holder owns at least five percent of the corporation's equity securities; however, for passive institutional investors, qualification is generally not required for a position of less than 10%, and upon a showing of good cause, qualification may be excused for a position of 10% or more. Failure to qualify could jeopardize our license. In addition, the New Jersey Racing Commission also licenses our subsidiary and retains concurrent regulatory oversight over this subsidiary with the Casino Commission.

        As a consequence of our sale of our Series A convertible preferred stock, in 2000 the Casino Control Act required our subsidiary that held a casino service industry license to relinquish said license upon the closing of that sale and apply anew for licensure. We obtained preliminary approval from the New Jersey Racing Commission and transactional waivers from the Casino Commission that allow us to continue providing services to Atlantic City casinos pending investigation of the new application that we filed and until our subsidiary is relicensed and our directors, officers and certain security holders are qualified. The holders of our Series A convertible preferred stock and certain of their directors, officers and shareholders may be required to seek qualification or to seek waiver of qualification. We believe that all the foregoing actions will be satisfactorily concluded in due course. However, there can be no assurance that this will be the case, and our failure to obtain any of the foregoing approvals could have a material adverse effect on us or our business plans.

        Our rights to operate the Connecticut OTB system are conditioned on our continuing to hold all licenses required for the operation of the system. In addition, our officers and directors and certain other employees must be licensed. Licensees are generally required to submit to background investigations and provide required disclosures. The Division of Special Revenue of the State of Connecticut, or the Division, may revoke the license to operate the system under certain circumstances, including a false statement in the licensing disclosure materials, a transfer of ownership of the licensed entity without Division approval and failure to meet financial obligations. The approval of the Connecticut regulatory authorities is required before any off-track betting facility is closed or relocated or any new branch or simulcast facility is established. Our telephone wagering operations, based in Connecticut, are subject to the Division's regulation. We have expanded the market for our

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"business-to-consumer" On the Wire® account wagering business through our Connecticut OTB from 13 states to 27 states.

        While in the past we have been the subject of enforcement proceedings instituted by one or more regulatory bodies, we have been able to consensually resolve any such proceedings upon the implementation of remedial measures and/or the payment of settlements or monetary fines to such bodies. However, there can be no assurance that similar proceedings in the future will be similarly resolved, or that such proceedings will not have a material adverse impact on our ability to retain and renew existing licenses or to obtain new licenses in other jurisdictions.

Video Gaming

        Coin or voucher operated gambling devices offering electronic, video versions of spinning reels, poker, blackjack and similar games are known as video gaming machines ("VGMs") or video lottery terminals ("VLTs"), depending on the jurisdiction. These devices represent a growing area in the wagering industry. We or our subsidiaries manufacture and supply terminals and wagering systems designed for use as VGMs or VLTs.

        Twenty-seven states and Puerto Rico authorize wagering on VGMs or VLTs at casinos, riverboats, racetracks and/or other licensed facilities. Although some states, such as Rhode Island, currently restrict VGMs or VLTs to already existing wagering facilities, others permit these devices to be placed at bars and restaurants as well. Several Native American tribes throughout the U.S. are also authorized to operate these devices on reservation lands. In addition, all of the Canadian provinces and various foreign countries have authorized their use.

        From time to time, government officials in other states consider proposals to legalize or expand video gaming or video lottery in their states. Many legislators have been enthusiastic about the potential of video gaming to raise significant additional revenues. Some officials, however, are reluctant to expand gaming industry opportunities or have expressed a desire to limit video gaming to established wagering facilities if video gaming is authorized in their jurisdiction at all.

        Companies that manufacture, sell or distribute VGMs or VLTs are subject to various provincial, state, county and municipal laws and regulations. The primary purposes of these rules are (i) to ensure the responsibility, financial stability and character of equipment manufacturers and their key personnel and stockholders through licensing requirements, (ii) to ensure the integrity and randomness of the machines, and (iii) to prohibit the use of VGMs or VLTs at unauthorized locations or for the benefit of undesirable individuals or entities. The regulations governing VGMs and VLTs generally resemble the pari-mutuel and sports wagering regulations in all the basic elements described above.

        However, every jurisdiction has differing terminal design and operational requirements, and terminals generally must be certified by local regulatory authorities before being distributed in any particular jurisdiction. These requirements may require us or our subsidiaries to modify our terminals to some degree in order to achieve certification in particular locales. In addition, the intrastate movement of such devices in a jurisdiction where they will be used by the general public is usually allowed only upon prior notification and/or approval of the relevant regulatory authorities.

        The West Virginia Lottery Commission has licensed us or our subsidiaries to supply VLTs to authorized pari-mutuel racing facilities in that state in accordance with the Racetrack Video Lottery Act.

        In Canada, one of our subsidiaries has been granted registration as a casino gaming related supplier by the Alcohol and Gaming Commission of Ontario in accordance with Ontario's Gaming Control Act, 1992 and by the Alberta Gaming and Liquor Commission in accordance with its Gaming and Liquor Act of Alberta. Another subsidiary has been granted interim registration as a gaming related supplier to the Manitoba Lottery Commission by the Manitoba Gaming Control Commission.

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The gaming laws of Ontario, Alberta, and Manitoba primarily deal with the responsibility, honesty, integrity and financial stability of gaming equipment manufacturers, distributors and operators as well as persons financially interested or involved in gaming operations. To ensure the integrity of manufacturers and suppliers of gaming supplies, gaming regulators in Ontario, Alberta and Manitoba have the authority to conduct thorough background investigations of us, our officers, directors, key personnel and significant stockholders who are required to file applications detailing their personal and financial information. The gaming regulators may at any time revoke, suspend, condition or restrict a registration for an appropriate cause as determined under the applicable gaming legislation. We believe that we are in compliance with the terms and conditions of our registrations in Ontario, Alberta and Manitoba.

        We may apply for all necessary licenses in other jurisdictions that may now or in the future authorize video gaming or video lottery operations. We cannot predict the nature of the regulatory schemes or the terminal requirements that will be adopted in any of these jurisdictions, nor whether we or any of our subsidiaries can obtain any required licenses and equipment certifications or will be found suitable.

        U.S. federal law also affects our video gaming industry activities. The Federal Gambling Devices Act of 1962, or the Devices Act, makes it unlawful for any person to manufacture, deliver or receive gambling devices, including VGMs and VLTs, across interstate lines unless that person has first registered with the Attorney General of the U.S., or to transport such devices into jurisdictions where their possession is not specifically authorized by state law. The Devices Act permits states to exempt themselves from its prohibition on transportation, and several states that authorize the manufacture or use of such devices within their jurisdictions have done so. Certain of our products, such as the PROBE® XLC terminal, are gaming devices subject to the Devices Act and state laws governing such devices. The Devices Act does not apply to machines designed for pari-mutuel wagering at a racetrack, such as our pari-mutuel wagering terminals. We have registered under the Devices Act and believe we are substantially in compliance with all of the Devices Act's record-keeping and equipment identification requirements.

Simulcasting

        The Federal Communications Commission regulates the use and transfer of earth station licenses used to operate our domestic simulcasting operations.

        At present, 43 states, Puerto Rico, all of the Canadian provinces, Mexico and many other foreign countries authorize interstate and/or intrastate pari-mutuel wagering, which may involve the simulcasting of the races in question. Licensing and other regulatory requirements associated with such simulcasting activities are similar to those governing pari-mutuel wagering and are generally enforced by pari-mutuel regulators. In addition, contracts with host tracks whose races are simulcast by us to other facilities within or outside the jurisdictions in which such races are held may be subject to approval by regulatory authorities in the jurisdictions from and/or to which the races are simulcast. We believe that we are in substantial compliance with applicable regulations and that we, and/or the appropriate third parties, have entered into contracts and obtained the necessary regulatory approvals to conduct current simulcast operations lawfully.

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Nevada Regulatory Matters

        We and certain of our wholly-owned subsidiaries are applicants or will be applicants for certain registrations, approvals, findings of suitability and licenses in the State of Nevada. There can be no assurances that the pending applications by us and our subsidiaries operating in Nevada will be approved or that, if approved, they will be approved on a timely basis or without conditions or limitations.

        The manufacture, sale and distribution of gaming devices for use or play in Nevada or for distribution outside of Nevada, the manufacture and distribution of associated equipment for use in Nevada, the operation of an off-track pari-mutuel wagering system in Nevada, the operation of an off-track pari-mutuel sports wagering system in Nevada and the operation of slot machine routes in Nevada are subject to: (i) the Nevada Gaming Control Act and the regulations promulgated thereunder, or the Nevada Act; and (ii) various local ordinances and regulations. Such activities are subject to the licensing and regulatory control of the Nevada Gaming Commission, or Nevada Commission, the Nevada State Gaming Control Board, or Nevada Board, and various local, city and county regulatory agencies.

        The laws, regulations and supervisory procedures of the Nevada gaming authorities are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming, or manufacturing or distribution of gaming devices at any time or in any capacity; (ii) the strict regulation of all persons, locations, practices, associations and activities related to the operation of licensed gaming establishments and the manufacture or distribution of gaming devices and equipment; (iii) the establishment and maintenance of responsible accounting practices and procedures; (iv) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada gaming authorities; (v) the prevention of cheating and fraudulent practices; and (vi) to provide a source of state and local revenues through taxation and licensing fees. Changes in such laws, regulations and procedures could have an adverse effect on our various applications in the event they are granted. No assurances can be given that the applications will be granted by the Nevada gaming authorities. The grant or denial of the applications is within the discretion of the Nevada gaming authorities.

        We are an applicant for registration by the Nevada Commission as a publicly traded corporation and are or will be an applicant to be found suitable to own the stock, both directly and indirectly of various wholly-owned subsidiaries which are or will be applicants for approvals and licensing as a manufacturer, distributor and operator of a slot machine route, an operator of an off-track pari-mutuel wagering system and an operator of an off-track pari-mutuel sports wagering system. As a registered corporation, we will be required periodically to submit detailed financial and operating reports to the Nevada Commission and furnish any other information that the Nevada Commission may require. No person may become a stockholder of, or receive any percentage of profits from, our subsidiaries operating in Nevada without first obtaining licenses and approvals from the Nevada gaming authorities. We and our subsidiaries operating in Nevada have or will apply to the Nevada gaming authorities for the various registrations, approvals, permits, findings of suitability and licenses in order to engage in manufacturing, distribution, slot route activities, and off-track pari-mutuel wagering systems operations in Nevada. The following regulatory requirements will apply to us and our subsidiaries operating in Nevada if they are approved and licensed. All gaming devices and cashless wagering systems that are manufactured, sold or distributed for use or play in Nevada, or for distribution outside of Nevada, must be manufactured by licensed manufacturers and distributed or sold by licensed distributors. All gaming devices manufactured for use or play in Nevada must be approved by the Nevada Commission before distribution or exposure for play. The approval process for gaming devices includes rigorous testing by the Nevada Board, a field trial and a determination as to whether the gaming device meets strict

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technical standards that are set forth in the regulations of the Nevada Commission. Associated equipment must be administratively approved by the Chairman of the Nevada Board before it is distributed for use in Nevada.

        The Nevada gaming authorities may investigate any individual who has a material relationship to, or material involvement with, us or our subsidiaries operating in Nevada in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of our subsidiaries operating in Nevada are required to file applications with the Nevada gaming authorities and may be required to be licensed or found suitable by the Nevada gaming authorities. Our officers, directors and key employees who are actively and directly involved in the licensed activities of our subsidiaries operating in Nevada may be required to be licensed or found suitable by the Nevada gaming authorities. The Nevada gaming authorities may deny an application for licensing for any cause that they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The entity with which the applicant is employed or for which the applicant serves must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada gaming authorities and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada gaming authorities have jurisdiction to disapprove a change in a corporate position.

        If the Nevada gaming authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with us or our subsidiaries operating in Nevada, the companies involved would have to sever all relationships with such person. In addition, the Nevada Commission may require us and our subsidiaries operating in Nevada to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada.

        We and our subsidiaries operating in Nevada will be required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar financing transactions by our subsidiaries operating in Nevada will be required to be reported to or approved by the Nevada Commission. If we are licensed by the Nevada gaming authorities, any (i) guarantees issued by our subsidiaries operating in Nevada in connection with any public financing; (ii) hypothecation of the assets of our subsidiaries operating in Nevada as security in connection with any financing; and/or (iii) pledges of the equity securities of our subsidiaries operating in Nevada as security in connection with any public financing will require the approval of the Nevada Commission to remain effective. If it were determined that the Nevada Act was violated by us or any of our subsidiaries operating in Nevada, the licenses we or they hold could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, any of our subsidiaries operating in Nevada, we and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Limitation, conditioning or suspension of the licenses held by us and our subsidiaries operating in Nevada could (and revocation of any license would) materially adversely affect our manufacturing, distribution and system operations in Nevada. Any beneficial holder of our voting securities, regardless of the number of shares owned, may be required to file an application, be investigated, and have his suitability determined as a beneficial holder of our voting securities if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the state of Nevada. The applicant must pay all costs of investigation incurred by the Nevada gaming authorities in conducting any such investigation. The Nevada Act requires any person who acquires beneficial ownership of more than 5% of a registered corporation's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of a registered corporation's voting securities apply to the Nevada Commission for a finding of suitability within thirty days after the Chairman of the Nevada Board mails

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the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10%, but not more than 15%, of the registered corporation's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the registered corporation, any change in the registered corporation's corporate charter, bylaws, management, policies or operations of the registered corporation, or any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the registered corporation's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be licensed or found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation.

        Also under the Nevada Act and under certain circumstances, an "institutional investor" as defined in the Nevada Act, which intends to acquire not more than 15% of any class of nonvoting securities of a privately-held corporation, limited partnership or limited liability company that is also a registered holding or intermediary company or the holder of a gaming license, may apply to the Nevada Commission for a waiver of the usual prior licensing or finding of suitability requirements if such institutional investor holds such nonvoting securities for investment purposes only. An institutional investor shall not be deemed to hold nonvoting securities for investment purposes unless the nonvoting securities were acquired and are held in the ordinary course of business as an institutional investor, do not give the institutional investor management authority, and do not, directly or indirectly, allow the institutional investor to vote for the election or appointment of members of the board of directors, a general partner or manager, cause any change in the articles of organization, operating agreement, other organic document, management, policies or operations, or cause any other action that the Nevada Commission finds to be inconsistent with holding nonvoting securities for investment purposes only. Activities that are not deemed to be inconsistent with holding nonvoting securities for investment purposes only include: (i) nominating any candidate for election or appointment to the entity's board of directors or equivalent in connection with a debt restructuring; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in the entity's management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of nonvoting securities who must be licensed or found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation.

        Any person who fails or refuses to apply for a finding of suitability or a license within thirty days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board, may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request, fails to identify the beneficial owner. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. We will be subject to disciplinary action if, after we receive notice that a person is unsuitable to be a stockholder or to have any other relationship with us, our subsidiaries operating in Nevada or we (i) pay that person any dividend or interest upon our voting securities, (ii) allow that person to exercise, directly or indirectly, any voting right conferred

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through securities held by that person, (iii) pay remuneration in any form to that person for services rendered or otherwise, or (iv) fail to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities including, if necessary, the immediate purchase of said voting securities for cash at fair market value.

        The Nevada Commission may, in its discretion, require the holder of any debt security of a registered corporation to file applications, be investigated and be found suitable to own the debt security of a registered corporation if the Nevada Commission has reason to believe that his acquisition of such debt security would otherwise be inconsistent with the declared policy of the State of Nevada. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the registered corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction.

        We and our subsidiaries operating in Nevada will be required to maintain a current stock ledger in Nevada, which may be examined by the Nevada gaming authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada gaming authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable. We are also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require our stock certificates to bear a legend indicating that the securities are subject to the Nevada Act.

        After becoming a registered corporation, we may not make a public offering of our securities without the prior approval of the Nevada Commission if the securities or proceeds from that sale are intended to be used to construct, acquire or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. Such approval, if given, does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful. While we are not yet subject to the provisions of the Nevada Act or the regulations of the Nevada Commission, such regulations also provide that any entity that is not an "affiliated company," as such term is defined in the Nevada Act, or which is not otherwise subject to the Nevada Act or such regulations, which plans to make a public offering of securities intending to use such securities, or the proceeds from the sale thereof, for the construction or operation of gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes, may apply to the Nevada Commission for prior approval of such offering. The Nevada Commission may find an applicant unsuitable based solely on the fact that it did not submit such an application, unless upon a written request for a ruling, the Nevada Board Chairman has ruled that it is not necessary to submit an application.

        Changes in control of a registered corporation through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a registered corporation must satisfy the Nevada Board and the Nevada Commission in a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction.

        The Nevada Legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada corporate gaming

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licensees, and registered corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate gaming licensees and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the registered corporation can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the registered corporation's Board of Directors in response to a tender offer made directly to the registered corporation's stockholders for the purposes of acquiring control of the registered corporation.

        License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to the counties and cities in which gaming operations are to be conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually and are based upon either: (i) a percentage of the gross revenues received; or (ii) the number of gaming devices operated. Annual fees are also payable to the State of Nevada for renewal of licenses as a manufacturer, distributor, operator of a slot machine route and operator of an off-track pari-mutuel wagering system.

        Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons, and who proposes to become involved in a gaming venture outside of Nevada, is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the Nevada Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, licensees are required to comply with certain reporting requirements imposed by the Nevada Act. A licensee is also subject to disciplinary action by the Nevada Commission if it knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the state of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability.

Application of Additional or Future Regulatory Requirements

        In the future, we intend to seek the necessary licenses, approvals and findings of suitability for us, our personnel and products in other jurisdictions throughout the world wherever significant sales are anticipated to be made. There can be no assurance, however, that such licenses, approvals or findings of suitability will be obtained or, if obtained, will not be conditioned, suspended or revoked or that we will be able to obtain the necessary approvals for any future products as they are developed. If a license, approval or a finding of suitability is required by a regulatory authority and we fail to obtain the necessary license, approval or finding, we may be prohibited from selling our products for use in the respective jurisdiction or may be required to sell our products through other licensed entities at a reduced profit.

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Executive Officers of the Company

        Our executive officers are elected each year at the annual meeting of the Board of Directors, which follows the annual meeting of stockholders, to hold office for a one-year term and until their successors have been elected and qualified or until their earlier death, resignation or removal.

        Certain information regarding each of our executive officers is set forth below.

Name

  Age
  Position

A. Lorne Weil

 

58

 

Chairman of the Board, President and Chief Executive Officer
Martin E. Schloss   57   Vice President, General Counsel and Secretary
DeWayne E. Laird   56   Vice President, Chief Financial Officer and Controller
William J. Huntley   54   Vice President of Lottery Systems and President, SGI Systems
Cliff O. Bickell   61   Vice President of Printed Products and President, SGI Printed Products
Brooks H. Pierce   42   Vice President of Pari-mutuel Operations and President, Autotote Systems
Robert C. Becker   45   Vice President and Treasurer
Sally L. Conkright   51   Vice President of Organization Development
Richard M. Weil   49   Vice President of International Business Development

        A. Lorne Weil has served as a director since December 1989, Chairman of the Board since October 31, 1991, Chief Executive Officer since April 1992, and President since August 1997. Mr. Weil held various senior management positions with the Company and its subsidiaries from October 1990 to April 1992 and was a director and consultant to Autotote Systems, Inc. from 1982 until it was acquired by the Company in 1989. Mr. Weil was President of Lorne Weil, Inc., a firm providing strategic planning and corporate development services to high technology industries, from 1979 to November 1992.

        Martin E. Schloss has served as Vice President and General Counsel since December 1992 and Secretary since May 1995. Prior to joining the Company, Mr. Schloss served in various positions in the legal department of General Instrument Corporation for approximately 15 years.

        DeWayne E. Laird has served as Vice President and Chief Financial Officer since November 1998 and corporate controller since April 1996. From January 1992 to March 1996, Mr. Laird was President of Laird Associates, PC, a CPA firm providing financial consulting services to a variety of industries. From April 1984 to December 1991, he held various senior positions with Philadelphia Suburban Corporation, including Chief Financial Officer and Treasurer.

        William J. Huntley has served as Vice President of Lottery Systems since October 2002 and as President of the Systems Division of Scientific Games International, Inc. since September 2000. Previously, Mr. Huntley served as President of Autotote Lottery Corporation from November 1997 until its merger into Scientific Games International, Inc. He served as Vice President of Autotote Systems, Inc. from June 1989 to November 1997 and as Vice President of Operations of the Company from 1991 to 1994.

        Cliff O. Bickell has served as Vice President of Printed Products since October 2002 and as President of the Printed Products Division of Scientific Games International, Inc. since our

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September 2000 acquisition of Scientific Games Holdings Corp. ("SGHC"). Mr. Bickell joined SGHC in 1995 and he has previously served as its Vice President, Treasurer and Chief Financial Officer. Prior to joining SGHC, Mr. Bickell was Vice President, Chief Financial Officer and Treasurer of Paragon Trade Brands, a multi-national consumer products manufacturer. In addition, Mr. Bickell has held positions as Senior Vice President, Corporate Administration-Chief Financial Officer of W.A. Krueger Co., a commercial printing company, and Treasurer of Dataproducts Corporation, a multinational electronics manufacturer.

        Brooks H. Pierce has served as Vice President of Pari-mutuel Operations since October 2002, and as President of Autotote Systems, Inc. since November 1997. Mr. Pierce previously served as Vice President of Autotote Systems, Inc. from November 1991 to November 1997.

        Robert C. Becker has served as Treasurer since October 1996 and as Vice President since April 2001. Prior to joining the Company, Mr. Becker served as Assistant Treasurer for the Fuller Company from 1990 to 1994.

        Sally L. Conkright has served as Vice President of Organizational Development since October 2002. Ms. Conkright served as Vice President of Converge, L.L.C. from 2001 to 2002, and as Director of Innovation & eLearning for Linkage, Inc. from 2000 to 2001. Ms. Conkright served as Director of Compensation and Benefits for Xerox Corporation from 1999 to 2000 and as Vice President of Human Resources and Public Relations for Xerox New Enterprises from 1997 to 1999.

        Richard M. Weil has served as Vice President of International Business Development since March 2002 and he has also served as Vice President of International Business Development of Scientific Games International, Inc. since October 2000. Previously, he was in charge of international business development for Autotote Systems, Inc. where he started as Vice President of Manufacturing in 1994. Prior to joining Autotote, Mr. Weil was a consultant for strategic planning and corporate development with several firms. Richard M. Weil is the brother of A. Lorne Weil, the Chairman of the Board, President and Chief Executive Officer of the Company.

Access to Public Filings

        We file annual, quarterly, current reports, proxy statements and other documents with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, as amended. The public may read and copy any materials that we file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including us, that file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

Available Information

        We make the following information available free of charge through the Investor Relations link on our website at www.scientificgames.com:

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ITEM 2. PROPERTIES

        The following is a list of facilities that we use in the operation of our business.

Business

  Location
  Square Feet
  Owned/
leased

  Purposes
Corporate   New York, NY   12,000   Leased   Corporate Headquarters
    Christiana, DE   8,000   Leased   Administration

Pari-Mutuel

 

Essen, Germany

 

12,000

 

Leased

 

Administration and operations
    Alpharetta, GA   32,000   Leased   Warehouse and office space
    Ballymahon, Ireland   19,000   Leased   Manufacturing and warehouse
    Various cities, France   6,300   Leased   Administration and operations
    Various cities, Germany   17,200   Leased   Warehouse and office space

Venue Management

 

Various cities, CT

 

56,300

 

Leased

 

OTB facilities
    Windsor Locks, CT   39,000   Owned   OTB facility
    New Haven, CT   55,000   Owned   OTB facility, administration and operations
    New Haven, CT   2,000   Leased   Administration
    Den Haag, Netherlands   16,000   Leased   Administration and operations
    Various cities,
The Netherlands
  23,500   Leased   OTB facilities

Lottery

 

Rocky Hill, CT

 

17,000

 

Leased

 

Administration and operations
    Barre, VT   3,100   Leased   Administration
    Concord, NH   5,400   Leased   Administration and operations
    Helena, MT   3,900   Leased   Administration and operations
    Urbandale, IA   35,000   Leased   Administration and operations
    Gardner, ME   10,000   Leased   Administration and operations
    Orlando, FL   50,000   Leased   Administration and operations
    Blythewood, SC   20,000   Leased   Administration and operations
    Vienna, Austria   46,300   Leased   Administration and operations
    Various   46,200   Leased   Warehouse space and operations
    Santiago, Chile   47,000   Leased   Administration, operations, warehousing and manufacturing
    Alpharetta, GA   260,000   Owned   Manufacturing and administration
    Duluth, GA   48,000   Leased   Warehouse space
    Phoenix, AZ   22,000   Leased   Administration and warehouse
    Middletown, PA   35,100   Leased   Administration and warehouse
    La Vergne, TN   23,600   Leased   Administration and warehouse
    Clifton, NJ   180,000   Leased   Administration and operations
    Baltimore, MD   27,600   Leased   Administration and operations
    Harrisburg, PA   24,700   Leased   Administration and operations
    Dover, DE   23,600   Leased   Administration and operations
    Indianapolis, IN   20,000   Leased   Administration and operations
    Charleston, WV   18,500   Leased   Administration and operations
    Arden Hills, MN   17,900   Leased   Administration and operations
    Sharon Hills, PA   12,000   Leased   Operations
    Orlando, FL   10,300   Leased   Administration and operations
    Various cities, FL   39,200   Leased   Administration and operations

Telecommunication Products

 

Leeds, England

 

150,000

 

Owned

 

Manufacturing

32



ITEM 3. LEGAL PROCEEDINGS

        Although we are a party to various claims and legal actions arising in the ordinary course of business, we believe, on the basis of information presently available to us, that the ultimate disposition of these matters will not likely have a material adverse effect on our consolidated financial position or results of operations.

        Our subsidiary, Scientific Games International, Inc. ("SGI"), owned a minority interest in Wintech de Colombia S.A., or Wintech (now in liquidation), which formerly operated the Colombian national lottery under contract with Empresa Colombiana de Recursos para la Salud, S.A. ("Ecosalud"), an agency of the Colombian government. The contract projected that certain levels of lottery ticket sales would be attained and provided a penalty against Wintech, SGI and the other shareholders of Wintech of up to $5.0 million if such performance levels were not achieved. In addition, with respect to a further guarantee of performance under the contract with Ecosalud, SGI delivered to Ecosalud a $4.0 million bond issued by a Colombian surety, Seguros del Estado ("Seguros"). Wintech started the instant lottery in Colombia, but, due to difficulties beyond its control, including, among other factors, social and political unrest in Colombia, frequently interrupted telephone service and power outages, and competition from another lottery being operated in a province of Colombia which we believe was in violation of Wintech's exclusive license from Ecosalud, the projected sales level was not met for the year ended June 30, 1993. On July 1, 1993, Ecosalud adopted resolutions declaring, among other things, that the contract was in default and asserted various claims for compensation and penalties against Wintech, SGI and other shareholders of Wintech. Litigation is pending and/or threatened in Colombia concerning various claims among Ecosalud, Wintech and SGI, relating to the termination of the contracts with Ecosalud. Ecosalud's claims are for, among other things, realization of the full amount of the penalty, plus interest and costs of the bond. In 2002 the Colombian Government enacted new gaming and lottery legislation which included the dissolution of Ecosalud. A new company, Empresa Territorial para la Salud ("Etesa") was incorporated replacing Ecosalud. Etesa is the legal successor to Ecosalud with respect to the pending litigation.

        The Colombian surety, Seguros, paid $2.4 million to Ecosalud under its $4.0 million bond, and made demand upon SGI for that amount under the indemnity agreement between the surety and SGI. SGI declined to make or authorize any such payment and notified the surety that any payment in response to Ecosalud's demand on the bond was at the surety's risk. In a case brought in U.S. District Court in Georgia, the Colombian surety sought to recover from SGI sums paid (in SGI's view, improperly) under its surety bond, plus interest. In September 1999, the District Court granted summary judgment for the surety in the amount of approximately $7 million (which included pre-judgment interest at a rate of 38.76% per annum). On appeal, the United States Court of Appeals for the Eleventh Circuit, on August 20, 2001, affirmed the judgment for the principal amount of $2.4 million, but vacated that part of the judgment awarding approximately $4.6 million based on a pre-judgment interest rate of 38.76% with instructions to the District Court to recalculate pre-judgment interest. On February 22, 2002, SGI agreed to settle this matter upon payment of $3.7 million to the Colombian surety. On February 26, 2002, SGI drew upon a $1.5 million letter of credit posted by a former Colombian partner in order to partially fund this payment. This settlement resolves the U.S. litigation with the surety, but the claims in Colombia remain unresolved.

        In July 2002, the Tribunal Contencioso of Cundinamarca denied SGI's preliminary motion to dismiss Etesa's pending lawsuit against SGI seeking the collection of amounts that Etesa claims are owed by SGI. By decision dated August 2003, of which SGI received notice in January 2004, such denial was upheld by the Council of State, the highest appellate court with jurisdiction over this matter. As a result of these decisions, this lawsuit, which is in its early stages, will be heard in due course on its merits by the Tribunal Contencioso of Cundinamarca.

33



        SGI has various defenses on the merits as well as procedural defenses that we plan to assert against Ecosalud's claims. We intend to vigorously pursue these defenses as appropriate. SGI also has certain cross indemnities and undertakings from the two other privately held shareholders of Wintech for their respective shares of any liability to Ecosalud. No assurance can be given that the other shareholders of Wintech will, or have sufficient assets to, honor their indemnity undertakings to SGI when the claims by Ecosalud against SGI and Wintech are finally resolved, in the event such claims result in any final liability. Although we believe that any potential losses arising from these claims will not result in a material adverse effect on our consolidated financial position or results of operations, it is not feasible to predict the final outcome, and there can be no assurance that these claims might not be finally resolved adversely to us or result in material liability.

        On October 26, 2002, we experienced a breach of security by an employee who altered betting data on the $3 million "winning" wagering ticket on the races constituting the Pick Six at the Breeders' Cup at Arlington Park in Illinois. It was subsequently discovered that the employee, whom we terminated, also altered betting data on two other multiple-race wagers earlier in the month.

        On December 4, 2002, a class action lawsuit (Allard v. Autotote / Scientific Games Corporation, and Does 1-10 (L. A. Superior Court No. BC 286382)) was filed against us in state court in California by a professional Pick Six bettor on behalf of pari-mutuel bettors in the U.S., alleging, among other things, negligence, breach of contract and deceptive trade practices arising from our handling of multiple-race wagers. We removed the case to federal court, and moved to dismiss the lawsuit. On June 2, 2003, the federal court judge dismissed the action finding that plaintiff's claims were barred as a matter of law and public policy. Subsequently, on July 8, 2003, the federal court judge determined that he did not have subject matter jurisdiction over the case and set aside his previous dismissal order and remanded the case to state court. We have moved to dismiss plaintiff's second amended complaint without leave to amend.

        Subsequent to the end of our 2003 fiscal year, on March 4, 2004, a lawsuit (GTech Corporation v. Scientific Games International, Inc., Scientific Games Holdings Corporation, Scientific Games Finance Corporation and Scientific Games Corporation (U.S. District Court for the District of Delaware, Civil Action No. 04-0138)) was filed against us in federal court in Delaware. The lawsuit alleges that we have infringed upon two patents owned by GTech Corporation concerning instant lottery ticket vending and dispensing machines and methods. We believe that the lawsuit lacks merit, and we intend to contest the suit vigorously.


ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        No matters were submitted to a vote of our security holders during the fourth quarter of fiscal year 2003.

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PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

        Since January 29, 2002, our outstanding common stock has been listed for trading on the Nasdaq National Market under the symbol "SGMS". Our common stock was previously traded on the American Stock Exchange. The following table sets forth, for the periods indicated, the range of high and low closing prices of our Class A common stock.

 
  Market Price of
Scientific Games
Common Stock

 
  High
  Low
Fiscal 2002 (January 1, 2002-December 31, 2002)        
  First Quarter   10.05   8.10
  Second Quarter   9.97   7.00
  Third Quarter   7.99   5.98
  Fourth Quarter   8.40   5.55
Fiscal 2003 (January 1, 2003-December 31, 2003)        
  First Quarter   7.41   4.85
  Second Quarter   9.35   5.13
  Third Quarter   12.35   8.22
  Fourth Quarter   16.97   11.57
Fiscal 2004        
  First Quarter through March 12, 2004   18.64   14.98

        On March 12, 2004, the last reported sale price for our common stock on the Nasdaq National Market was $17.84 per share. There were approximately 1,466 holders of record of our common stock as of March 12, 2004.

        We have never paid any cash dividends on our Class A common stock. The Board presently intends to retain all earnings, if any, for use in the business. Any future determination as to payment of dividends will depend upon our financial condition and results of operations and such other factors as are deemed relevant by the Board. Further, under the terms of the Indenture governing our 121/2% Senior Subordinated Notes, we and our Restricted Subsidiaries (as defined) are limited in our ability to pay any cash dividends or make certain other restricted payments (other than stock dividends) on our Class A common stock.

Recent Sales of Unregistered Securities; Use of Proceeds From Registered Securities

        The terms of our outstanding Series A Convertible Preferred Stock provide for quarterly dividends at a rate equal to 6% per annum, which are payable in kind in the form of additional shares of such preferred stock or, beginning in 2004, in cash at our option. In 2003, we issued an aggregate of 76,605 shares of our Series A Convertible Preferred Stock, pro rata to the holders of such outstanding preferred stock, as quarterly dividend payments on such preferred stock. The Series A Convertible Preferred Stock was originally issued in a private transaction exempt from registration under the Securities Act in reliance on Section 4(2) thereof.

        In April 2003, the holders of warrants to purchase 43,036 shares of Class A Common Stock at $3.32 per share originally issued to lenders in 1995 exercised their warrants on a cashless basis by electing to have us withhold a number of shares having a market value equal to the purchase price of approximately $142,880. As a result of this exercise, the holders were issued 18,180 shares and the remaining 24,856 warrant shares were withheld as payment of the exercise price. The shares were

35



issued in a private transaction exempt from registration under the Securities Act in reliance on Section 4(2) thereof.

        In October 2003, the holders of warrants to purchase 146,793 shares of Class B Common Stock at $3.83 per share (originally issued to lenders in 1992) exercised their warrants for the aggregate purchase price of $562,674. The holders elected to convert their shares into Class A common stock, which shares have been registered for resale pursuant to a Registration Statement on Form S-3 (Registration No. 333-110477) under the Securities Act of 1933, which was declared effective on February 12, 2004. The shares were issued in a private transaction exempt from registration under the Securities Act in reliance on Section 4(2) thereof.

        For additional information regarding our Series A Preferred Stock, see Note 12 and Exhibit 3.(i), which exhibit is hereby incorporated by this reference.


ITEM 6. SELECTED FINANCIAL DATA

        Selected historical financial data presented below as of and for the years ended October 31, 1999 and 2000, the two months ended December 31, 2000 and the years ended December 31, 2001 and 2002 have been derived from our audited consolidated financial statements which have been audited by KPMG LLP, independent auditors. Selected financial data presented below as of and for the year ended December 31, 2003 have been derived from our audited consolidated financial statements which have been audited by Deloitte & Touche LLP, independent auditors. The following financial information reflects the acquisitions of certain businesses during the period 1999 through 2003, including the acquisition of SGHC since September 6, 2000, the acquisition of 65% of the equity of Serigrafica Chilena S.A. ("SERCHI") since June 5, 2002, the acquisition of MDI Entertainment, Inc. since January 10, 2003 and the acquisition of IGT OnLine Entertainment Systems, Inc. ("OES") since November 6, 2003. In connection with the acquisition of SGHC, we changed our fiscal year from an October 31 year-end to a calendar year-end, beginning with the year ended December 31, 2001. As a result, the following summary presents selected financial data for the years ended October 31, 1999 and 2000, the two-month transition period ended December 31, 2000 and the years ended December 31, 2001, 2002 and 2003. Reclassifications to Prior Years' Consolidated Financial Statements: Effective January 1, 2003, we adopted FASB Statement No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds Statement No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect, and requires the criteria in Accounting Principles Board Opinion No. 30 to be used to classify gains and losses. Accordingly, in 2002, we reclassified the extraordinary losses incurred in 2000 and 2002 to early extinguishment of debt. These debt extinguishment costs totaled $12,567 in 2000 and $22,501 in 2002. Certain reclassifications have been made to prior year's amounts to conform to current presentation. These data should be read in conjunction with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements and the Notes thereto, included in Item 8 of this Form 10-K.

36



FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA
(in thousands, except per share amounts)

 
  Years Ended
October 31,

   
  Years Ended
December 31,

 
  Two Months
Ended
December 31,
2000

 
  1999
  2000(b)
  2001
  2002
  2003
Selected Statement of Operations Data:                          
Operating Revenues:                          
  Services   $ 148,660   186,520   57,584   364,567   382,818   452,564
  Sales     62,488   46,828   9,007   75,674   72,435   108,347
   
 
 
 
 
 
      211,148   233,348   66,591   440,241   455,253   560,911
   
 
 
 
 
 
Costs and Expenses:                          
  Cost of services     99,496   126,601   39,592   231,285   221,038   247,730
  Cost of sales     43,937   29,299   5,547   47,158   47,412   76,082
  Amortization of service contract software     2,180   1,765   517   4,366   4,930   5,312
  Selling, general and administrative     27,178   35,664   9,902   56,695   63,132 (d) 80,074
  Depreciation and amortization (h)     20,009   25,735   7,755   49,132   37,905   42,373
  Interest expense     16,177   31,231   8,790   50,363   44,842 (e) 26,397
  Other (income) expense     15   (456 ) (247 ) 37   636   1,184
  Early extinguishment of debt       12,567 (c)     22,501 (f) 293
  Loss on sale of businesses     1,600 (a)        
   
 
 
 
 
 
Total costs and expenses     210,592   262,406   71,856   439,036   442,396   479,445
   
 
 
 
 
 
Income (loss) before income tax expense (benefit)     556   (29,058 ) (5,265 ) 1,205   12,857   81,466
Income tax expense (benefit)     177   1,603   (465 ) 6,067   (26,875 )(g) 29,319
   
 
 
 
 
 
Net income (loss)     379   (30,661 ) (4,800 ) (4,862 ) 39,732   52,147
Convertible preferred paid-in-kind dividend       1,014   1,143   7,051   7,484   7,661
   
 
 
 
 
 
Net income (loss) available to common stockholders   $ 379   (31,675 ) (5,943 ) (11,913 ) 32,248   44,486
   
 
 
 
 
 
Basic and diluted income (loss) per share:                          
Basic net income (loss) available to common stockholders (h)   $ 0.01   (0.86 ) (0.15 ) (0.30 ) 0.64   0.74
   
 
 
 
 
 
Diluted net income (loss) available to common stockholders (h)   $ 0.01   (0.86 ) (0.15 ) (0.30 ) 0.50   0.59
   
 
 
 
 
 
Weighted average number of shares used in per share calculation:                          
  Basic shares     36,118   36,928   40,025   40,340   50,221   60,010
   
 
 
 
 
 
  Diluted shares     38,343   36,928   40,025   40,340   80,151   88,143
   
 
 
 
 
 
Selected Balance Sheet Data (End of Period):                          
Total assets   $ 165,559   608,449   598,527   585,796   636,789   962,989
Total long-term debt, including current installments   $ 157,144   443,834   440,680   439,735   360,529   532,163
Stockholders' equity (deficit)   $ (48,219 ) 34,645   28,593   20,240   168,770   237,152
   
 
 
 
 
 

        The following notes are an integral part of these selected historical consolidated financial data.

(a)
Reflects $1,600 of unusual loss resulting from the sale of our SJC Video business.

(b)
In the fourth quarter of the fiscal year ended October 31, 2000, we recognized unusual interest expense charges in the amount of $7,511 attributable to payments, in the form of warrants to

37


(c)
Reflects early extinguishment of debt costs of $12,567 incurred in connection with the write-off of deferred financing fees and payment of the call premium on the repayment of our 107/8% Series B Senior Notes.

(d)
Includes approximately $1,100 of accrued incremental costs associated with the Pick Six matter.

(e)
Includes $3,300 in debt restructuring charges related to interest rate swaps that were settled in connection with the refinancing of our 2000 senior secured credit facility (the "2000 Facility").

(f)
Reflects early extinguishment of debt costs of $10,226 incurred in connection with the write-off of deferred financing fees related to our refinancing of the 2000 Facility, the payment of $11,172 of redemption premium from the repurchase of a portion of our 121/2% Senior Subordinated Notes and the payment of $1,103 in bank fees to permit us to use a majority of the net proceeds from the July 2002 public offering and sale of 14,375 shares of our Class A Common Stock at a price of $7.25 per share to redeem subordinated debt.

(g)
Includes an income tax benefit of $32,900 from the recognition of net operating loss carryforwards ("NOL") at December 31, 2002.

(h)
On January 1, 2002, we adopted Statement No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized. Instead, they will be tested for impairment at least annually in accordance with the provisions of SFAS 142.

38


        The following table compares the pro forma net income (loss) available to common stockholders for the years ended October 31, 1999, and 2000, the two months ended December 31, 2000, and the year ended December 31, 2001, adjusted to reflect the adoption of SFAS 142 as if it had occurred at the beginning of the periods presented, to the reported net income (loss) available to common stockholders for the years ended December 31, 2002 and 2003:

 
  Year Ended
October 31,

   
  Year Ended
December 31,

 
  Two Months
Ended
December 31,
2000

 
  1999
  2000
  2001
  2002
  2003
 
  Pro Forma

  Pro Forma

  Pro Forma

  Pro Forma

  As Reported

  As Reported

Adjusted income available to common stockholders:                          
Adjusted income (loss)   $ 2,610   (27,927 ) (3,335 ) 5,251   39,732   52,147
   
 
 
 
 
 
Adjusted net income (loss) available to
common stockholders
  $ 2,610   (28,941 ) (4,478 ) (1,800 ) 32,248   44,486
   
 
 
 
 
 
Adjusted earnings per share amounts—basic and diluted:                          
Adjusted net income (loss) per share available to common stockholders:                          
  Basic   $ 0.07   (0.78 ) (0.11 ) (0.04 ) 0.64   0.74
   
 
 
 
 
 
  Diluted   $ 0.07   (0.78 ) (0.11 ) (0.04 ) 0.50   0.59
   
 
 
 
 
 
Shares used in calculating adjusted
per share amounts:
                         
  Basic     36,118   36,928   40,025   40,340   50,221   60,010
   
 
 
 
 
 
  Diluted     38,343   36,928   40,025   40,340   80,151   88,143
   
 
 
 
 
 
Reconciliation of reported net income to adjusted net income:                          
  Reported net income (loss) available to common stockholders   $ 379   (31,675 ) (5,943 ) (11,913 ) 32,248   44,486
Add back:                          
  Amortization of goodwill and intangible assets with indefinite lives, net of tax benefit     2,231   2,734   1,465   10,113    
   
 
 
 
 
 
  Adjusted net income (loss) available to common stockholders   $ 2,610   (28,941 ) (4,478 ) (1,800 ) 32,248   44,486
   
 
 
 
 
 

39



ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Background

        We are a leading worldwide provider of services, systems and products to both the instant ticket lottery industry and the pari-mutuel wagering industry based on revenues. We believe we offer our customers the widest array of some of the most technologically advanced products and services in each of these industries. We also believe that we are the world's only fully integrated lottery service provider, offering lottery authorities on-line lottery systems, instant tickets and cooperative services programs.

        On November 6, 2003, we acquired IGT OnLine Entertainment Systems, Inc. ("OES") from International Game Technology. OES operates on-line lottery systems in seven states and the Caribbean, and supports systems sold to customers in Korea, Norway, Switzerland and Shanghai. The acquisition also included OES's Advanced Games System (AGS) video system contracts in six jurisdictions throughout the world, certain intellectual property and an exclusive license to specific IGT slot brands for both instant and on-line games. Upon consummation of the acquisition, we changed the name of OES to Scientific Games Online Entertainment Systems, Inc. The excess of the $143.0 million purchase price, plus expenses and a working capital payment of approximately $7.0 million, over the fair values of the net assets acquired is currently estimated to be approximately $102.2 million and has been recorded as goodwill. This estimate is subject to revisions until the valuations of OES's assets and liabilities are finalized. The operating results of OES have been included in the Company's consolidated operating results since the date of acquisition. Had the operating results of OES been included as if the transaction had been consummated on January 1, 2003, the Company's pro forma revenue and net income available to common shareholders for the twelve months ended December 31, 2003 would have been $688.0 million and $49.3 million, respectively.

        On January 17, 2003, we completed the acquisition of MDI Entertainment, Inc. ("MDI") through (i) a tender offer at $1.60 per share, in cash, (ii) the purchase of shares from MDI's President and Chief Executive Officer pursuant to a separate stock purchase agreement and (iii) a merger, whereby the remaining eight percent of MDI common shares was converted into the right to receive $1.60 per share in cash. With the purchase of MDI, we significantly expanded our offerings of licensed branded products and prize fulfillment and related services. MDI focuses on helping lotteries attract players to new kinds of tickets and second chance games that allow players to win merchandise, such as Harley-Davidson motorcycles and trips and prizes such as tickets to NBA playoff games. Our portfolio of licensed brands now includes Hasbro, Mandalay Bay, NBA, Harley-Davidson, Wheel-of-Fortune, and many others. The exclusive licenses from Hasbro include Monopoly®, Battleship® and Scrabble®. The acquisition of MDI has enabled us to further expand the use of branded games and prize fulfillment services to continue to help its customers generate revenues to meet the needs of their beneficiaries. The acquisition was recorded using the purchase method of accounting and the acquired assets and liabilities have been recorded at their estimated fair values at the date of acquisition. The excess of the approximately $23.0 million purchase price over the fair values of the net assets acquired is approximately $22.2 million and has been recorded as goodwill. The operating results of MDI have been included in our consolidated operating results since January 10, 2003. Had the operating results of MDI been included as if the transaction had been consummated on January 1, 2003, our pro forma operating results for the year ended December 31, 2003 would not have been materially different from the actual reported results.

        On June 5, 2002, we completed the acquisition of 65% of the equity of Serigrafica Chilena S.A. ("SERCHI"). Subsequent to the acquisition, we changed the name of SERCHI to Scientific Games Latino America S.A. The purchase price was approximately $3.9 million in cash and up to $4.4 million in cash or stock payable to SERCHI stockholders upon the achievement of certain financial performance levels of SERCHI over the next four years. In 2003 we paid an additional $0.9 million in

40



cash for achievement of certain financial performance levels in 2002. The acquisition was recorded using the purchase method of accounting and the acquired assets and liabilities have been recorded at their estimated fair values at the date of acquisition. The operating results of the SERCHI business have been included in the consolidated statements of operations since the date of acquisition.

        Our revenues are derived from two principal sources: service revenues and sales revenues. Service revenues are generally earned pursuant to multi-year contracts to provide instant ticket and related services and on-line and pari-mutuel wagering systems and services, or are derived from wagering by customers at facilities we own or lease. We believe our service revenues are recurring in nature. Sales revenues are derived from sales of prepaid phone cards and from the sale of wagering systems, equipment, and software licenses.

        We operate primarily in four business segments: Lottery Group, Pari-mutuel Group, Venue Management Group and Telecommunications Products Group.

        Our Lottery Group derives revenues from the sale of instant lottery tickets and related services and the sale or operation of on-line lottery systems. In 2003, our Lottery Group accounted for approximately 65% of all retail sales of instant lottery tickets in the United States. In the instant ticket business, we typically sell our tickets for a per unit price or are paid a fee equal to a percentage of the retail value of the instant tickets sold by a state lottery. In the on-line lottery market in the United States, we are generally paid a fee equal to a percentage of all dollars wagered on lottery tickets; in international markets, we generally sell our lottery systems to the lottery operators. "On-line" lottery refers to a computerized system in which lottery terminals in retail outlets are continuously connected to a central computer system for the sale and validation of lottery tickets and related functions.

        Our Lottery Group provides instant tickets and related services and lottery systems. Instant ticket and related services includes ticket design and manufacturing as well as value-added services, including game design, sales and marketing support, inventory management and warehousing and fulfillment services. In addition, this division includes promotional instant tickets and pull-tab tickets that we sell to both lottery and non-lottery customers. Our lottery systems business includes the supply of transaction processing software for the accounting and validation of both instant ticket and on-line lottery games, point-of-sale terminal hardware sales, central site computers and communication hardware sales, and ongoing support and maintenance services for these products. This business line also includes software, hardware and support service for sports betting and credit card processing systems. We have contracts to operate on-line lottery systems for 16 of the 42 on-line lottery authorities in the U.S., and we believe we are the second largest on-line lottery provider in Europe.

        Our Pari-mutuel Group is a leading worldwide provider of wagering systems to the pari-mutuel wagering industry, to which we also provide related race broadcasting and telecommunications services. Our Pari-mutuel Group is comprised of our North American and international on-track, off-track and inter-track pari-mutuel services, simulcasting and communications services, and video gaming, as well as sales of pari-mutuel systems and equipment. We provide our systems and services to thoroughbred, harness and greyhound racetracks, OTBs, casinos, jai alai frontons and other establishments where pari-mutuel wagering is permitted. We are generally paid a percentage of all racing industry wagers, or Handle, processed by our wagering systems, and we receive a service fee for our satellite communications services on a per event or a monthly subscription basis. In 2003, our systems processed approximately 65% of the estimated $20 billion in pari-mutuel wagering conducted on racing in North America.

        Our Venue Management Group includes our Connecticut OTB operations and our Dutch on-track and off-track betting operations.

        Our Telecommunications Products Group is comprised of our prepaid cellular phone card business.

41



        The first and fourth quarters of the calendar year traditionally comprise the weakest seasons for our pari-mutuel wagering businesses. As a result of inclement weather during the winter months, a number of racetracks do not operate and those that do operate often experience missed racing days. This adversely affects the amounts wagered and our corresponding service revenues. Wagering equipment sales and software license revenues usually reflect a limited number of large transactions, which do not recur on an annual basis. Consequently, revenues and operating results can vary substantially from period to period as a result of the timing of revenue recognition for major equipment sales and software license revenue. In addition, instant ticket and prepaid phone card sales may vary depending on the season and timing of contract awards, changes in customer budgets, ticket inventory levels, lottery retail sales and general economic conditions.

        Operating results may also vary significantly from period to period depending on the addition or disposition of business units in each period. The acquisition of 65% of the equity of SERCHI in 2002, the acquisition of MDI in January 2003 and the acquisition of OES in November 2003, all of which were accounted for as purchases, affect the comparability of operations from period to period (see Note 3 to the Consolidated Financial Statements).

        On January 29, 2002, we transferred the listing for our Class A common stock to the Nasdaq National Market, and our trading symbol was changed to "SGMS".

Critical Accounting Policies

        The SEC defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.

        The following is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for management's judgment in their application. There are also areas in which management's judgment in selecting an available alternative would not produce a materially different result.

        We have identified the following as accounting policies critical to us: revenue recognition, valuation of long-lived and intangible assets and goodwill, income taxes and management estimates.

Revenue recognition

        The Company recognizes revenue when persuasive evidence of an arrangement exists, the price to the buyer is fixed or determinable, collectibility is reasonably assured, and delivery has occurred. Almost all of our revenues, except revenues earned from the sale of wagering systems, are earned pursuant to contractual terms and conditions either as a percentage of the amount wagered or when products are shipped to the customer and the customer assumes ownership of the product. Such revenues do not involve difficult, subjective or complex judgments.

        Revenues from fixed price contracts to provide wagering systems including equipment and software licenses are recognized on the percentage of completion method of accounting based on the ratio of costs incurred to estimated total costs to complete with revisions to estimated costs reflected in the period in which changes become known. Anticipated losses on fixed price contracts are recognized when the losses can be estimated. Recognition of revenue under the percentage of completion method requires us to make estimates regarding the resources required or the scope of work to be performed. If we do not accurately estimate the extent of work to be performed, manage our projects properly or complete our contracts within the specified time period, we may experience changes in revenues and resulting reductions in margins or losses on our contracts in subsequent periods.

42



        At the time we enter into service or sales contracts, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of our fee is due beyond our normal payment terms, which may vary depending on the nature of the contract and location of the customer, we account for the fee as not being fixed and determinable and recognize the revenue when payments become due. We assess collection based on a number of factors, including past transaction history with the customer and the credit worthiness of the customer. For our international customers, we frequently require collateral in the form of a letter of credit for all or a portion of our fee. If we determine collection is not reasonably assured, we defer the fee and recognize the revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.

Valuation of long-lived and intangible assets and goodwill

        We assess the recoverability of long-lived assets and intangible assets and goodwill whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Factors we consider important which could trigger an impairment review include:

        When we determine that the carrying value of the long-lived assets, intangible assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on the projected discounted cash flow, using a discount rate equal to our weighted average cost of capital, or by a comparison to third party indications of fair market value. At December 31, 2003, the net carrying value of our long-lived assets, intangible assets and goodwill amounted to approximately $662 million.

        In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"), we ceased amortizing goodwill and intangible assets determined to have indefinite useful lives as of January 1, 2002. Statement of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141"), and SFAS 142 require that we evaluate our existing goodwill and intangible assets and make any necessary reclassifications to conform with the new criteria outlined in SFAS 141 and SFAS 142. We completed our assessment of goodwill and intangible assets in the second quarter of 2002, and we made all necessary reclassifications to goodwill in accordance with the provisions of SFAS 142. No material adjustments were made to the goodwill and intangible assets balances at December 31, 2001. We also evaluated the remaining useful lives of the intangible assets that will continue to be amortized and have determined that no revision to those useful lives is necessary. We performed an annual impairment test for fiscal 2002 and 2003, and no adjustment was required to the carrying value of our goodwill or intangible assets with indefinite useful lives as of December 31, 2002 or 2003.

Income Taxes

        Income taxes are calculated using the asset and liability method under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"). Under this method, deferred income taxes are calculated by applying enacted statutory tax rates to cumulative temporary

43



differences between financial statement carrying amounts and the tax basis of existing assets and liabilities. Under SFAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

        Prior to 2002, we had a history of losses, which generated sizable net operating loss carryforwards for both state and federal tax purposes. We did not recognize any income tax benefits from those losses in excess of the amount of net taxable temporary differences that would reverse during the carryforward period because we were not able to demonstrate that it was more likely than not that we would generate sufficient taxable income in the future to utilize some or all of these net operating losses, and, accordingly, we recorded a valuation allowance offsetting our deferred tax asset associated with these losses. Because of improved financial results in 2002, and anticipated taxable income in 2003 and beyond, it was determined that it was more likely than not that we would utilize our tax losses to offset future taxable income considering any limitations on the use of our tax losses imposed by the Internal Revenue Code of 1986. As a result, we recorded a deferred tax asset in 2002 of approximately $30.1 million by reducing the corresponding deferred income tax valuation allowance, and recognized an income tax benefit in income from continuing operations. Should our expectations for future levels of taxable income not materialize or occur in amounts significantly less than what we have forecasted, some of our deferred tax assets may not be recoverable. A significant change in our expectations for future taxable income could have a material effect on our consolidated results of operations and financial position.

Management estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Some of the more significant estimates made by management involve percentage of completion for contracted lottery and pari-mutuel wagering systems, as discussed above, evaluation of the recoverability of assets including accounts receivable, inventories and long-lived assets and the assessment of litigation and contingencies, and income taxes.

        Management specifically evaluates the recoverability of accounts receivable by analyzing historical bad debts, customer concentrations, customer credit-worthiness, past collection experiences with specific customers, current economic trends and changes in customer payment terms. We do not require our customers to provide collateral for services provided pursuant to our service contracts. For sales of equipment and wagering systems to international customers we generally require that no less than a significant portion of the amounts to be paid be collateralized by irrevocable letters of credit. Changes in the underlying financial condition of our customers could result in a material impact to our results of operation and financial position.

        Our inventory consists principally of parts and finished goods to which we provide a reserve for obsolete and slow moving items. We continually evaluate the adequacy of our reserves by reviewing historical rates of scrap, on-hand quantities as compared to historical and projected usage levels, orders for new equipment, and contractual requirements to service our installed base of equipment.

        We record a liability pertaining to pending litigation based on our best estimate of a potential loss, if any, or at the minimum end of the range of loss in circumstances where the range of loss can be reasonably estimated. Because of uncertainties surrounding the nature of litigation and the ultimate liability to us, if any, we continually revise our estimated losses as additional facts become known.

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Related Party Transactions

        Statement of Financial Accounting Standards No. 57, Related Party Disclosures, requires us to identify and describe material transactions involving related persons or entities and to disclose information necessary to understand the effects of such transactions on our consolidated financial statements. We are not a party to material transactions involving related persons or entities.

Reclassification of Previously Reported Extraordinary Item

        Effective January 1, 2003, we adopted FASB Statement No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds Statement No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect, and requires the criteria in Accounting Principles Board Opinion No. 30 to be used to classify gains and losses. Accordingly, in 2003, we reclassified the extraordinary losses incurred in 2002 to early extinguishment of debt. These debt extinguishments totaled approximately $22.5 million of pre-tax expense in 2002. Certain other reclassifications were made to the prior years' consolidated financial statements to conform to the current presentation.

Results of Operations

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

        The following analysis compares our results of operations for the year ended December 31, 2003 to the results for the year ended December 31, 2002.

 
  Year Ended December 31, 2003
 
  Lottery
Group

  Pari-
Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
 
  (in thousands)

Service revenues   $ 307,820   80,798   63,946       452,564
Sales revenues     54,685   5,399     48,263     108,347
   
 
 
 
 
Total revenues     362,505   86,197   63,946   48,263     560,911
   
 
 
 
 
Cost of service     159,447   43,476   44,807       247,730
Cost of sales     40,884   2,790     32,408     76,082
Amortization of service contract software     2,947   2,365         5,312
   
 
 
 
 
Total operating expense     203,278   48,631   44,807   32,408     329,124
   
 
 
 
 
Gross profit     159,227   37,566   19,139   15,855     231,787
Selling, general and administrative expenses     40,538   11,208   3,403   4,998     60,147
Depreciation and amortization     25,319   11,718   2,001   2,630     41,668
   
 
 
 
 
Segment operating income   $ 93,370   14,640   13,735   8,227     129,972
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       20,632
                     
Consolidated operating income                     $ 109,340
                     
Interest expense                     $ 26,397
                     

45


 
  Year Ended December 31, 2002
 
  Lottery
Group

  Pari-
Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
 
  (in thousands)

Service revenues   $ 239,219   81,546   62,053       382,818
Sales revenues     20,721   5,692     46,022     72,435
   
 
 
 
 
Total revenues     259,940   87,238   62,053   46,022     455,253
   
 
 
 
 
Cost of service     131,602   46,677   42,759       221,038
Cost of sales     14,474   2,751     30,187     47,412
Amortization of service contract software     2,328   2,602         4,930
   
 
 
 
 
Total operating expenses     148,404   52,030   42,759   30,187     273,380
   
 
 
 
 
Gross profit     111,536   35,208   19,294   15,835     181,873
Selling, general and administrative expenses     26,900   10,675   2,821   4,520     44,916
Depreciation and amortization     21,646   11,679   1,789   2,241     37,355
   
 
 
 
 
Segment operating income   $ 62,990   12,854   14,684   9,074     99,602
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       18,766
                     
Consolidated operating income                     $ 80,836
                     
Interest expense                     $ 44,842
                     

Revenue Analysis

        For the year ended December 31, 2003, revenues of $560.9 million improved $105.7 million or 23% overall as compared to the prior year, reflecting a $69.7 million or 18% increase in service revenue and a $35.9 million or 50% increase in sales revenue.

        The increase in service revenue for the year ended December 31, 2003 was primarily attributable to a $68.6 million or 29% increase in revenues in the Lottery Group as compared to the prior year, of which $25.2 million represents an improvement in licensed branded lottery products and prize fulfillment and related services, primarily attributable to the addition of MDI beginning January 10, 2003, $21.8 million is attributable to the acquisition of OES in November 2003; $21.7 million is attributable to improvements in lottery sales, reflecting governments' continuing reliance on lotteries to support government sponsored programs; and $3.5 million is attributable to the strengthening of the euro. Pari-mutuel Group service revenues were approximately $0.7 million or 1% lower than the prior year period primarily due to lower Handle caused by severe winter weather conditions in the northeast, the war in Iraq, a slowing economy and a horsemen's strike in Chicago, partially offset by favorable foreign exchange rates. Venue Management Group service revenues increased approximately $1.9 million or 3% compared to the prior year due primarily to more favorable exchange rates in The Netherlands.

        The $35.9 million increase in sales revenue for the year ended December 31, 2003 is primarily attributable to higher levels of systems and equipment sales in the Lottery Group, coupled with a $2.2 million or 5% improvement in revenues in the Telecommunications Products Group as compared to the prior year, due primarily to the impact of favorable exchange rates, partially offset by lower prices.

Gross Profit Analysis

        Gross profit of $231.8 million for the year ended December 31, 2003 increased $49.9 million or 27% as compared to the prior year, reflecting a $42.7 million or 27% improvement in service revenues, and a $7.2 million or 29% improvement in sales revenues. Margin improvements related to service

46



revenues as compared to the prior year period were primarily attributable to the Lottery Group, as continued cost reduction efforts coupled with higher revenues, plus the addition of MDI in January 2003 and OES in November 2003. Gross margins improved from 40% in 2002 to 41% in 2003. Increased lottery systems and equipment sales revenue contributed to the $7.2 million or 29% increase in gross margin on sales in the Lottery Group for the year as compared to 2002. The $2.4 million or 7% improvement in gross margin in the Pari-mutuel Group reflects the benefits of continued cost reduction efforts, partially offset by lower Handle-related service revenues as explained above. Telecommunications Products Group gross margins were unchanged in 2003 from the prior year, as more favorable exchange rates and increased volume were offset by lower prices.

Expense Analysis

        Selling, general and administrative expenses of $80.1 million for the year ended December 31, 2003 were $16.9 million or 27% higher than for 2002. This increase is primarily due to $10.0 million of incremental selling, general and administrative expenses for SERCHI, MDI and OES, plus a $4.5 million increase in sales and marketing costs, compensation, medical costs and professional service fees, and $3.0 million in costs associated with the relocation of our pari-mutuel racing operations from Delaware to Georgia.

        Depreciation and amortization expense, including amortization of service contract software, of $47.7 million for the year ended December 31, 2003 increased $4.9 million or 11% from 2002, primarily due to the acquisitions of SERCHI, MDI and OES, and the amortization of deferred installation costs of new lottery contracts.

        Interest expense of $26.4 million for the year ended December 31, 2003 decreased $18.4 million or 41% from 2002, primarily as a result of the debt reduction program begun in 2002. (See "Liquidity, Capital Resources and Working Capital.")

Income Tax Expense

        Income tax expense of $29.3 million for the year ended December 31, 2003 increased $56.2 million from a tax benefit of $26.9 million in 2002 due to the recognition of a $30.1 million income tax benefit from the net operating loss carryforward in the year ended December 31, 2002. As a result of our recognition of the income tax benefit of the net operating loss carryforward in 2002, the financial statement income tax provision increased from approximately 15% in 2002 to approximately 36% in 2003. Our cash tax rate in 2003 was approximately 16% as a result of utilizing some of our tax losses to offset taxes that would otherwise be payable. No current tax benefit was recognized on domestic operating losses prior to 2002 in excess of the amount of net taxable temporary differences that are expected to reverse during the NOL carryforward period.

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Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

        The following analysis compares our results of operations for the year ended December 31, 2002 to the results for the year ended December 31, 2001.

 
  Year Ended December 31, 2002
 
  Lottery
Group

  Pari-
Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
 
  (in thousands)

Service revenues   $ 239,219   $ 81,546   $ 62,053   $   $ 382,818
Sales revenues     20,721     5,692         46,022     72,435
   
 
 
 
 
Total revenues     259,940     87,238     62,053     46,022     455,253
   
 
 
 
 
Cost of service     131,602     46,677     42,759         221,038
Cost of sales     14,474     2,751         30,187     47,412
Amortization of service contract software     2,328     2,602             4,930
   
 
 
 
 
Total operating expenses     148,404     52,030     42,759     30,187     273,380
   
 
 
 
 
Gross profit     111,536     35,208     19,294     15,835     181,873
Selling, general and administrative expenses     26,900     10,675     2,821     4,520     44,916
Depreciation and amortization     21,646     11,679     1,789     2,241     37,355
   
 
 
 
 
Segment operating income   $ 62,990     12,854     14,684     9,074     99,602
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                             18,766
                           
Consolidated operating income                           $ 80,836
                           
Interest expense                           $ 44,842
                           
 
  Year Ended December 31, 2001
 
  Lottery
Group

  Pari-
Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
 
  (in thousands)

Service revenues   $ 223,875   79,779   60,913       364,567
Sales revenues     13,936   19,554     42,184     75,674
   
 
 
 
 
Total revenues     237,811   99,333   60,913   42,184     440,241
   
 
 
 
 
Cost of service     141,442   46,663   43,180       231,285
Cost of sales     9,602   11,817     25,739     47,158
Amortization of service contract software     1,705   2,661         4,366
   
 
 
 
 
Total operating expenses     152,749   61,141   43,180   25,739     282,809
   
 
 
 
 
Gross profit     85,062   38,192   17,733   16,445     157,432
Selling, general and administrative expenses     25,635   10,738   2,625   4,935     43,933
Depreciation and amortization     32,217   12,131   2,674   1,804     48,826
   
 
 
 
 
Segment operating income   $ 27,210   15,323   12,434   9,706     64,673
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       13,068
                     
Consolidated operating income                     $ 51,605
                     
Interest expense                     $ 50,363
                     

48


Revenue Analysis

        For the year ended December 31, 2002, revenues of $455.3 million improved $15.0 million or 3.4% overall as compared to the prior year, reflecting an $18.3 million or 5.0% increase in service revenue and a $3.2 million or 4.3% decrease in sales revenue.

        The increase in service revenues in 2002 is primarily attributable to a $15.3 million or 7% increase in revenues in the Lottery Group, of which approximately $5.0 million is attributable to a full year of operation of the Maine and Iowa lotteries which started in mid-2001; approximately $11.0 million is attributable to the startup of the South Carolina Educational Lottery in January 2002; approximately $2.0 million is attributable to continued growth in the instant ticket sales; and approximately $5.0 million is attributable to the acquisition of SERCHI in June 2002. These gains were partially offset by the absence of the French lottery business that was sold in the third quarter of 2001. Cooperative services revenues were down slightly for the year as increased revenues at all of our other customers helped offset the loss of approximately $9.0 million of revenues from the loss of the New York contract, which was awarded to another vendor prior to our acquisition of Scientific Games Holdings Corp. ("SGHC") in September 2000. Pari-mutuel Group service revenues increased $1.8 million or 2%, primarily reflecting the additional revenue from the Churchill Downs simulcasting contract in 2002 and increased service fees. Venue Management Group service revenues increased $1.1 million or 2%, of which $0.5 million is attributable to the opening of the Hartford Raceview Center in 2002, plus continued growth in telephone account wagering, partially offset by a full year reduction in the New York Racing Association take-out rate. The balance of the increase is attributable to our Dutch operation, primarily due to higher Handle and a favorable exchange rate.

        The $3.2 million decrease in sales revenues in 2002 is primarily attributable to a $13.9 million decrease in sales revenue in the Pari-mutuel Group reflecting the completion in 2001 of a systems and equipment contract to the Turkey Jockey Club. This decrease was partially offset by a $6.8 million increase in systems and equipment sales revenue in the Lottery Group and a $3.8 million or 9% increase in prepaid phone card sales in the Telecommunications Group reflecting the benefit from a 33% increase in volume, partially offset by product unit price decreases.

Gross Profit Analysis

        Gross profit increased $24.4 million or 16% in 2002 reflecting an improvement of $27.9 million on service revenues, partially offset by a decrease of $3.5 million on lower sales revenues. The increase in service revenues discussed above contributed approximately $8.0 million to this gross margin improvement, with cost control measures contributing an additional benefit of approximately $20.5 million, including benefits of approximately $1.0 million in the Pari-mutuel Group and $1.2 million in the Venue Management Group. In addition, cost control measures amounting to approximately $5.7 million, in addition to increased volume, nearly offset the effect of selling price reductions in the prepaid phone card business.

Expense Analysis

        Selling, general and administrative expenses of $63.1 million in the year ended December 31, 2002 were $6.4 million higher than in the same period in 2001, primarily due to $1.1 million of investigation and other costs attributable to the Pick Six matter (see "Business: Security"), the reversal in the prior year period of a $1.5 million litigation reserve when a lawsuit was settled, coupled with higher proposal costs, professional services and compensation.

        Depreciation and amortization expense, including amortization of service contract software, of $42.8 million in the year ended December 31, 2002 decreased $10.7 million from $53.5 million in the same period in 2001. Depreciation expense increased $1.6 million in the year ended December 31, 2002 from the same period in 2001, primarily as a result of higher depreciation on new computer systems and terminals acquired in connection with the start-up of the new on-line lotteries. Amortization expense was $12.2 million lower in the year ended December 31, 2002 than in the same period in 2001, primarily as a result of the adoption of SFAS 141 and SFAS 142 effective January 1, 2002.

49


        Interest expense of $44.8 million in the year ended December 31, 2002 decreased $5.5 million from $50.4 million in the same period in 2001, primarily due to lower average debt levels following the third quarter 2002 repurchase of $83.0 million of our 121/2% Senior Subordinated Notes, plus the effect of lower average interest rates on our outstanding term loans. In addition, interest expense in the year ended December 31, 2002 included approximately $3.3 million of termination charges relating to the refinancing of our 2000 senior secured credit facility (the "2000 Facility") in December 2002. These charges resulted from the early cancellation of three interest rate swap agreements that we were required to maintain pursuant to the terms of the prior credit facility. (See "Liquidity, Capital Resources and Working Capital" for a discussion of the 2002 Offering, the repurchase of our 121/2% Senior Subordinated Notes and the replacement of the 2000 Facility with a 2002 Senior Secured Credit Facility.)

Early Extinguishment of Debt

        In 2002, we repaid approximately $83.0 million of our outstanding 121/2% Senior Subordinated Notes and refinanced the 2000 Facility. As a result, we recorded early extinguishment of debt aggregating approximately $22.5 million related to the redemption premium paid in the amount of approximately $11.2 million on the redeemed Notes; the $1.1 million fee paid to the term loan lenders to permit us to use the majority of the net proceeds from the 2002 Offering (see "Liquidity, Capital Resources and Working Capital") to redeem the Notes; and the write off of approximately $10.2 million of previously deferred financing costs.

Income Tax Expense

        We recorded an income tax benefit of $26.9 million in the year ended December 31, 2002. Prior to 2002, we had a history of losses, which generated sizable net operating loss carryforwards for both state and federal tax purposes. We did not recognize any income tax benefits from those losses in excess of the amount of net taxable temporary differences that would reverse during the carryforward period because we were not able to demonstrate that it was more likely than not that we would generate sufficient taxable income in the future to utilize some or all of these net operating losses, and, accordingly, we recorded a valuation allowance offsetting our deferred tax asset associated with these losses. Because of improved financial results in 2002, and anticipated taxable income in 2003 and beyond, it was determined that it was more likely than not that we would utilize our tax losses to offset future taxable income considering any limitations on the use of our tax losses imposed by the Internal Revenue Code of 1986. As a result, we recorded a deferred tax asset in 2002 of approximately $30.1 million by reducing the corresponding deferred income tax valuation allowance, and recognized an income tax benefit in income from continuing operations.

        In the year ended December 31, 2001, we recorded an income tax expense of $6.1 million, representing primarily state and foreign taxes. No current tax benefit was recognized in the year ended December 31, 2001 on the then remaining unrecorded value of the domestic net operating loss carryforwards.

Liquidity, Capital Resources and Working Capital

        In July 2002, we completed the public offering and sale of 14.4 million shares of our Class A Common Stock at a price of $7.25 per share (the "2002 Offering") and used the net proceeds of approximately $98.4 million (after deducting underwriting discounts, commissions and prior to deducting offering expenses) to redeem approximately $83.0 million of our 121/2% Senior Subordinated Notes ("Notes"). As a result of these transactions, our capital structure improved, and Standard & Poor's Ratings Group and Moody's Investors Service, Inc. upgraded our credit ratings to BB- and Ba3, respectively, where they remain today. In December 2002, we replaced our existing senior secured credit facility (the "2000 Facility") with a new senior secured credit facility (the "2002 Facility"), which

50



consisted of a $50.0 million revolving credit facility due 2006 and a $290.0 million Term B Loan due 2008. In May 2003, we repurchased an additional $1.5 million of our Notes. In November 2003, we amended and restated the 2002 Facility (as amended and restated, the "2003 Facility"). The 2003 Facility consists of a $75.0 million revolving credit facility due 2006 and a $462.8 million Term C Loan due 2009. The 2003 Facility contains certain financial covenants that are identical to those contained in the 2002 Facility, and which are described below. At December 31, 2003, approximately 88% of our debt, representing approximately $466.5 million of indebtedness, was in variable rate instruments. Consequently, we are exposed to fluctuations in interest rates. The effect of a 0.125% change in the interest rates associated with our unhedged variable rate debt will result in a change of approximately $0.6 million per year in our interest expense assuming no change in our outstanding borrowings.

        Our financing arrangements as of December 2003 impose certain limitations on our and our subsidiaries' operations.

        The credit agreement governing the 2003 Facility (the "Amended Credit Agreement") contains certain covenants that, among other things, limit our ability, and the ability of certain of our subsidiaries, to incur additional indebtedness, pay dividends or make distributions or certain other restricted payments, purchase or redeem capital stock, make investments or extend credit, engage in certain transactions with affiliates, engage in sale leaseback transactions, consummate certain assets sales, effect a consolidation or merger, or sell, transfer, lease or otherwise dispose of all or substantially all assets, and create certain liens and other encumbrances on assets. Additionally, the Credit Agreement governing the 2003 Facility contains the following financial covenants, which are computed quarterly on a rolling four-quarter basis as applicable:

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        For purposes of the foregoing limitations, Consolidated EBITDA means the sum of (i) consolidated net income, (ii) consolidated interest expense with respect to all outstanding indebtedness, (iii) provisions for taxes based on income, (iv) total depreciation expense, (v) total amortization expense and (vi) certain adjustments, in each case for the period being measured, all of the foregoing as determined on a consolidated basis for us and our subsidiaries in accordance with GAAP. Although we were in compliance with our loan covenants at December 31, 2003 and expect to continue to remain in compliance over the next 12 months, no assurances can be provided that we will be able to do so or that we will be able to continue to meet the covenant requirements beyond 12 months.

        At December 31, 2003, we had outstanding letters of credit of $47.9 million, but no outstanding borrowings under the 2003 Facility, leaving us with a total availability of $27.1 million as compared to $28.2 million at December 31, 2002. Our ability to borrow under the 2003 Facility will depend on our remaining in compliance with the limitations imposed by our lenders, including the maintenance of the specified financial covenants. Presently we have not sought and, therefore, do not have any other financing commitments.

        Our contractual obligations and commercial commitments principally include obligations associated with our outstanding indebtedness and future minimum operating lease obligations, as set forth in the table below:

 
  Cash Payments Due by Period

Contractual Obligations:

  Total

  Within 1 Year
  2-3 Years
  4-5 Years
  After 5 Years
 
  (in thousands)

Long term debt, 121/2% notes and 2003 Facility   $ 528,409   4,628   9,256   9,256   505,269
Other long term debt     3,754   1,699   1,009   500   546
Interest expense (1)     154,649   26,447   52,141   52,424   23,637
Operating leases     36,651   11,732   14,054   6,115   4,750
Other long term liabilities (2)     9,840     3,575   4,040   2,225
   
 
 
 
 
Total contractual cash obligations   $ 733,303   44,506   80,035   72,335   536,427
   
 
 
 
 

(1)
Based on rates in effect at December 31, 2003.

(2)
Because of the uncertainty as to the timing of such payments, we have excluded cash payments related to our contractual obligations for our pension plans and deferred compensation plans aggregating $21,091 at December 31, 2003. We have also excluded liabilities aggregating $10,647 at December 31, 2003, related to deferred revenues, deferred income taxes and minority interests in businesses we own.

        Our Series A Preferred Stock requires dividend payments at a rate of 6% per annum. To date, we have satisfied the dividend requirement using additional shares of convertible preferred stock. The terms of the convertible preferred stock provide us with the flexibility to satisfy the dividend in cash, subject to compliance with the 2003 Facility, which we expect to initiate in 2004.

        Our pari-mutuel wagering and on-line lottery systems service contracts require us to, among other things, maintain the central computing system and related hardware in efficient working order, provide added software functionality upon request, provide on-site computer operators, and furnish necessary supplies. Our primary expenditures associated with these services are personnel and related costs, which are expensed as incurred and are included in Operating Expenses-Services in the consolidated statements of operations. Historically, the revenues we derive from our service contracts have exceeded the direct costs associated with fulfilling our obligations under these pari-mutuel wagering and lottery systems service contracts. We expect that we will continue to realize positive cash flow and operating

52



income as we extend or renew existing service contracts. We also expect that we will enter into new contracts that are accretive to our cash flow. In addition, through advancements in technology, we are continually deploying more efficient and cost effective methods for manufacturing and delivering our products and services to our customers. We expect that technological efficiencies will continue to positively impact our future cash flows and operating results. We are not party to any other material short-term or long-term obligations or commitments pursuant to these service contracts.

        Periodically, we bid on new pari-mutuel and on-line lottery contracts. Once awarded, these contracts generally require significant up-front capital expenditures for terminal assembly, customization of software, software and equipment installation and telecommunications configuration. Historically we have funded these up-front costs through cash flows generated from operations, available cash on hand and borrowings under our credit facilities. Our ability to continue to procure new contracts will depend on, among other things, our then present liquidity levels and/or our ability to enter into additional borrowings at commercially acceptable rates to finance the initial up front costs. Once operational, long term service contracts have been accretive to our operating cash flow. For fiscal 2004, we anticipate that capital expenditures and software expenditures will be approximately $60.0 million. However, the actual level of expenditures will ultimately depend on the extent to which we are successful in winning new contracts. The amount of capital expenditures in fiscal 2005 and beyond will largely depend on the extent to which we are successful in winning new contracts. Furthermore, our pari-mutuel wagering network consists of approximately 26,000 wagering terminals. Periodically, we elect to upgrade the technological capabilities of older terminals and replace terminals that have exhausted their useful lives. We presently have no commitments to replace our existing terminal base and our obligation to upgrade the terminals is discretionary. Servicing our installed terminal base requires that we maintain a supply of parts and accessories on hand. We are also required, contractually in some cases, to provide spare parts over an extended period of time, principally in connection with our systems and terminal sale transactions. To meet our contractual obligations and maintain sufficient levels of on-hand inventory quantities to service our installed base, we purchase inventory on an as-needed basis. We presently have no inventory purchase obligations.

        At December 31, 2003, our available cash and borrowing capacity totaled $106.5 million compared to $63.1 million at December 31, 2002. Our available cash and borrowing capacities fluctuate principally based on the timing of collections from our customers, cash expenditures associated with new and existing pari-mutuel wagering and lottery systems contracts, repayment of our outstanding debt and changes in our working capital position. For the year ended December 31, 2003, net cash provided by operating activities of $115.0 million exceeded cash used in investing activities of $77.1 million, excluding funds used to acquire MDI and OES. The $115.0 million of net cash provided by operating activities consisted of the excess of the $122.5 million that was provided by operations less the $7.5 million that was used to fund changes in working capital. The working capital changes occurred principally from increases in accounts receivable and inventory, partially offset by increases in accounts payable and accrued liabilities.

        We believe that our cash flow from operations, available cash and available borrowing capacity under the 2003 Facility will be sufficient to meet our liquidity needs, including anticipated capital expenditures, for the foreseeable future; however, we cannot assure you that this will be the case. While we are not aware of any particular trends, our contracts periodically renew and we cannot assure you that we will be successful in sustaining our cash flow from operations through renewal of our existing contracts or through the addition of new contracts. In addition, lottery customers in the United States generally require service providers to provide performance bonds in connection with each state contract. Our ability to obtain performance bonds on commercially reasonable terms is subject to prevailing market conditions, which may be impacted by economic and political events. Although we have not experienced any difficulty obtaining such bonds, we cannot assure you that we will continue to be able to obtain performance bonds on commercially reasonable terms or at all. While we are not

53



aware of any reason to do so, if we need to refinance all or part of our indebtedness, including our 121/2% Senior Subordinated Notes, on or before maturity, or provide letters of credit or cash in lieu of performance bonds, we cannot assure you that we will be able to obtain new financing or to refinance any of our indebtedness, including the 2003 Facility and our 121/2% Senior Subordinated Notes, on commercially reasonable terms or at all.

New Accounting Pronouncements

        In December 2003, the Financial Accounting Standards Board (the "FASB") issued Statement No. 132 (revised 2003) Employers' Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106 ("SFAS 132 Amended"). SFAS 132 Amended revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers' Accounting for Pensions, No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits ("SFAS 87"), and No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions ("SFAS 106"). SFAS 132 Amended retains the disclosure requirements contained in FASB Statement No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits ("SFAS 132"), which it replaces. It requires additional disclosures to those in the original SFAS 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information is to be provided separately for pension plans and for other postretirement benefit plans. The provisions of SFAS 132 remain in effect until the provisions of SFAS 132 Amended are adopted. Except as noted below, SFAS 132 Amended is effective for the Company in the year 2003 financial statements. Disclosure of information about foreign plans required by paragraphs 5(d), 5(e), 5(g), and 5(k) of SFAS 132 Amended and disclosure of estimated future benefit payments required by paragraph 5(f) of SFAS 132 Amended are effective for fiscal year 2004.

        In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS 150"). SFAS 150 requires that certain financial instruments which have characteristics of both liabilities and equity be classified as liabilities, or, in some circumstances, assets, if they fall within the scope of SFAS 150. We were required to adopt SFAS 150 for all financial instruments entered into or modified after May 31, 2003, and on July 1, 2003 for all other financial instruments. The adoption of SFAS 150 did not have a material impact on our consolidated operations or financial position.

        In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities("SFAS 149"). SFAS 149 requires that contracts with comparable characteristics be accounted for similarly, clarifies under what circumstances a contract meets the characteristics of a derivative, clarifies when a derivative contains a financing component and amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45. We are required to adopt SFAS 149 for all contracts entered into or modified after September 30, 2003. The adoption of SFAS 149 did not have a material impact on our consolidated operations or financial position.

        In December 2002 the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("Interpretation No. 46"), which elaborates on Accounting Research Bulletin No. 51, Consolidated Financial Statements, to address consolidation by business enterprises of variable interest entities (previously often referred to as special purpose entities), which have one or both of the following characteristics:

54


        Interpretation No. 46 applies immediately to variable interest entities created after January 31, 2003. It applies in the first fiscal year or interim period beginning after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Company does not have any variable interest rate entities, and we do not expect that Interpretation No. 46 will have an impact on our financial statements.

        In November 2002, the EITF reached a consensus on Issue 00-21, Multiple Deliverable Revenue Arrangements ("EITF 00-21"). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. It also addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early application permitted. Companies may elect to report the change in accounting as a cumulative effect of a change in accounting principle in accordance with APB Opinion 20, Accounting Changes and SFAS 3, Reporting Accounting Changes in Interim Financial Statements-an amendment of APB Opinion No. 28. We believe that our current accounting is consistent with the provisions of EITF 00-21.

        On March 12, 2003, the FASB added to its agenda a project that will seek to improve the accounting and disclosures relating to stock-based compensation. Among other issues, the project on stock-based compensation will address whether to require that the cost of employee stock options be treated as an expense. The FASB plans to start deliberating the key issues on this subject at future public meetings with a view to issuing an Exposure Draft in 2004 that could become effective in 2004.

Recent Developments

        On February 17, 2004, the United States Patent and Trademark Office issued us a patent for our "Method of Playing A Group Participation Game." This is our third patent for this game family. The patents apply to lottery, casino, horse and dog racing and jai alai games that have an optional bonus wager as a feature of the game. We obtained this intellectual property with the purchase of OES.

55


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        Our products and services are sold to a diverse group of customers throughout the world. As such, we are subject to certain risks and uncertainties as a result of changes in general economic conditions, sources of supply, competition, foreign exchange rates, tax reform, litigation and regulatory developments. The diversity and breadth of our products and geographic operations mitigate the risk that adverse changes from any single event would materially affect our financial position.

        Additionally, as a result of the diversity of our customer base, we do not consider ourselves exposed to concentration of credit risks. These risks are further minimized by setting credit limits, ongoing monitoring of customer account balances, and assessment of the customers' financial strengths.

        Inflation has not had an abnormal or unanticipated effect on our operations. Inflationary pressures would be significant to our business if raw materials used for instant lottery ticket production, prepaid phone card production or terminal manufacturing are significantly affected. Available supply from the paper and electronics industries tends to fluctuate and prices may be affected by supply.

        For fiscal 2003, inflation was not a significant factor in our results of operations, and we were not impacted by significant pricing changes in our costs, except for personnel related expenditures. We are unable to forecast the prices or supply of substrate, component parts or other raw materials in 2004, but we currently do not anticipate any substantial changes that will materially affect our operating results.

        In certain limited cases, our lottery contracts with our customers contain provisions to adjust for inflation on an annual basis, but we cannot be assured that this adjustment would cover raw material price increases or other costs of services. While we have long-term and generally satisfactory relationships with most of our suppliers, we also believe alternative sources to meet our raw material and production needs are available.

        In the normal course of business, we are exposed to fluctuations in interest rates and equity market risks as we seek debt and equity capital to sustain our operations. At December 31, 2003, approximately 12% of our debt was in fixed rate instruments. We consider the fair value of all financial instruments to be not materially different from their carrying value at year-end. The following table provides information about our financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. In the third quarter of 2002, we completed the 2002 Offering and used approximately $83.0 million of the net proceeds to redeem a portion of our 121/2% Senior Subordinated Notes. In the fourth quarter of 2002 we replaced our senior secured credit facility with the 2002 Facility. In the fourth quarter of 2003 we amended and restated our senior credit facility, repaying the Term B Loan with a portion of the proceeds of a $462.8 million Term C Loan due 2009, and increasing the revolving credit facility to $75.0 million. (See "Liquidity, Capital Resources and Working Capital".)

Principal Amount by Expected Maturity—Average Interest Rate
December 31, 2003

 
  2004
  2005
  2006
  2007
  2008
  There
after

  Total
  Fair value
 
  (dollars in thousands)

Long-term debt:                                  
Fixed interest rate   $           65,584   65,584   77,553
Interest rate               12.5 % 12.5 %  
Variable interest rate   $ 6,329   5,249   5,040   4,977   4,762   440,222   466,579   464,890
Average interest rate     4.80 % 4.13 % 3.98 % 3.97 % 3.92 % 3.92 % 3.94 %  

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        We entered into derivative contracts to hedge part of our foreign currency exposure with respect to future cash receipts under our contract with the Ontario Lottery Commission. These instruments, which had a notional value of 34.7 million Canadian dollars at December 31, 2003, have been designated as cash flow hedges. For the year ended December 31, 2003, we recorded a debit to other comprehensive income (loss) of ($1.3) million for the change in the fair value of these foreign exchange instruments.

        The following table provides notional amounts and exchange rate information about our Canadian currency hedge derivative financial instruments. We do not hold any market risk instruments for trading purposes.

Notional Amount by Expected Maturity—Canadian Currency Hedge
December 31, 2003

 
  2004
  2005
  2006
  2007
  2008
  There
after

  Total
  Fair value
 
 
  (dollars in thousands)

 
Canadian currency hedge:                                    
Notional U.S. $amount   $ 25,925             25,925   (793 )
Exchange rate     1.34             1.34    

        We are also exposed to fluctuations in foreign currency exchange rates as the financial results of our foreign subsidiaries are translated into U.S. dollars in consolidation. Assets and liabilities outside the United States are primarily located in the United Kingdom, Germany, Netherlands, France, Austria and Chile. Our investment in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term investments. Accordingly, we do not hedge these net investments. Translation gains and losses historically have not been material. We manage our foreign currency exchange risks on a global basis by one or more of the following: (i) securing payment from our customers in U.S. dollars, when possible, (ii) utilizing borrowings denominated in foreign currency, and (iii) entering into foreign currency exchange contracts. In addition, a significant portion of the cost attributable to our foreign operations is incurred in the local currencies. We believe that a 10% adverse change in currency exchange rates would not have a significant adverse effect on our net earnings or cash flows. We may, from time to time, enter into foreign currency exchange or other contracts to hedge the risk associated with certain firm sales commitments, anticipated revenue streams and certain assets and liabilities denominated in foreign currencies.

        Our cash and cash equivalents and investments are in high-quality securities placed with a wide array of institutions with high credit ratings. This investment policy limits our exposure to concentration of credit risks.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

 
  Form 10-K
(Page)


Independent Auditors' Report

 

59

Independent Auditors' Report

 

60

Consolidated Financial Statements:

 

 
 
Balance Sheets as of December 31, 2002 and 2003

 

61
 
Statements of Operations for the years ended December 31, 2001, 2002 and 2003

 

62
 
Statements of Stockholders' Equity and Comprehensive Income (Loss) for the years ended December 31, 2001, 2002 and 2003

 

63
 
Statements of Cash Flows for the years ended December 31, 2001, 2002 and 2003

 

64

Notes to Consolidated Financial Statements

 

66

Schedule:

 

 

II. Valuation and Qualifying Accounts

 

115

        All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.

58



INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of
Scientific Games Corporation
New York, New York

        We have audited the accompanying consolidated balance sheet of Scientific Games Corporation and subsidiaries as of December 31, 2003, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for the year then ended. Our audit also included the financial statement schedule for the year ended December 31, 2003 listed in the Index at Schedule II. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit.

        We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Scientific Games Corporation and subsidiaries as of December 31, 2003, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the year ended December 31, 2003, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.

        As described in Note 1 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" effective January 1, 2003.

    /s/ Deloitte & Touche LLP

Atlanta, Georgia
March 15, 2004

59



INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Scientific Games Corporation:

        We have audited the accompanying consolidated balance sheet of Scientific Games Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for the years ended December 31, 2001 and 2002. In connection with our audits of the consolidated financial statements, we have also audited the 2001 and 2002 financial statement schedule as listed in the accompanying index. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Scientific Games Corporation and subsidiaries as of December 31, 2002, and the results of their operations and their cash flows for the years ended December 31, 2001 and 2002, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the 2001 and 2002 related financial statement schedule, when considered in relation to the 2001 and 2002 basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

        As discussed in Note 6 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" effective January 1, 2002.

    /s/ KPMG LLP

Short Hills, New Jersey
February 21, 2003

60



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
December 31, 2002 and 2003
(in thousands, except per share amounts)

 
  2002
  2003
 
ASSETS            
Current assets:            
  Cash and cash equivalents   $ 34,929   79,373  
  Accounts receivable, net of allowance for doubtful accounts of $3,772 and $4,589 in 2002 and 2003, respectively     53,260   99,639  
  Inventories     20,535   26,896  
  Prepaid expenses, deposits and other current assets     22,654   31,457  
   
 
 
    Total current assets     131,378   237,365  
   
 
 
Property and equipment, at cost     404,685   473,610  
  Less accumulated depreciation     203,819   244,880  
   
 
 
    Net property and equipment     200,866   228,730  
   
 
 
Goodwill, net     183,770   308,355  
Operating right, net     14,020   14,020  
Other intangible assets, net     43,802   77,428  
Other assets and investments     62,953   97,091  
   
 
 
Total assets   $ 636,789   962,989  
   
 
 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 
Current liabilities:            
  Current installments of long-term debt   $ 3,865   6,327  
  Accounts payable     23,888   34,603  
  Accrued liabilities     53,513   113,261  
  Interest payable     3,597   4,232  
   
 
 
    Total current liabilities     84,863   158,423  
   
 
 
Deferred income taxes     4,174   4,595  
Other long-term liabilities     22,318   36,983  
Long-term debt, excluding current installments     356,664   525,836  
   
 
 
    Total liabilities     468,019   725,837  
   
 
 
Commitments and contingencies (Notes 10 and 22)            

Stockholders' equity:

 

 

 

 

 

 
  Series A convertible preferred stock, par value $1.00 per share, 1,600 shares authorized, 1,248 and 1,325 shares outstanding at December 31, 2002 and 2003, respectively     1,248   1,325  
  Series B preferred stock, par value $1.00 per share, 2 shares authorized, 1.238 shares and 1.238 shares outstanding at December 31, 2002 and 2003     1   1  
  Class A common stock, par value $0.01 per share, 199,300 shares authorized, 59,375 and 61,504 shares outstanding at December 31, 2002 and 2003, respectively     594   615  
  Class B non-voting common stock, par value $0.01 per share, 700 shares authorized, none outstanding        
  Additional paid-in capital     384,927   405,957  
  Accumulated losses     (214,135 ) (169,649 )
  Treasury stock, at cost     (3,539 ) (6,743 )
  Accumulated other comprehensive income (loss)     (326 ) 5,646  
   
 
 
    Total stockholders' equity     168,770   237,152  
   
 
 
Total liabilities and stockholders' equity   $ 636,789   962,989  
   
 
 

See accompanying notes to consolidated financial statements.

61



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2001, 2002 and 2003
(in thousands, except per share amounts)

 
  Years Ended December 31,
 
  2001
  2002
  2003
Operating revenues:              
  Services   $ 364,567   382,818   452,564
  Sales     75,674   72,435   108,347
   
 
 
      440,241   455,253   560,911
   
 
 
Operating expenses (exclusive of depreciation and amortization shown below):              
  Services     231,285   221,038   247,730
  Sales     47,158   47,412   76,082
  Amortization of service contract software     4,366   4,930   5,312
   
 
 
      282,809   273,380   329,124
   
 
 
    Gross profit     157,432   181,873   231,787
   
 
 
Selling, general and administrative expenses     56,695   63,132   80,074
Depreciation and amortization     49,132   37,905   42,373
   
 
 
    Operating income     51,605   80,836   109,340
Other deductions:              
  Interest expense     50,363   44,842   26,397
  Other expense, net     37   636   1,184
  Early extinguishment of debt       22,501   293
   
 
 
      50,400   67,979   27,874
   
 
 
  Income before income tax expense (benefit)     1,205   12,857   81,466
Income tax expense (benefit)     6,067   (26,875 ) 29,319
   
 
 
  Net income (loss)     (4,862 ) 39,732   52,147
Convertible preferred stock paid-in-kind dividend     7,051   7,484   7,661
   
 
 
Net income (loss) available to common stockholders   $ (11,913 ) 32,248   44,486
   
 
 
Basic and diluted net income (loss) per share:              
  Basic net income (loss) available to common stockholders   $ (0.30 ) 0.64   0.74
   
 
 
  Diluted net income (loss) available to common stockholders   $ (0.30 ) 0.50   0.59
   
 
 
Weighted average number of shares used in per share calculations:              
  Basic shares     40,340   50,221   60,010
   
 
 
  Diluted shares     40,340   80,151   88,143
   
 
 

See accompanying notes to consolidated financial statements.

62


SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
Years Ended December 31, 2001, 2002 and 2003
(in thousands)

 
  Years Ended December 31,
 
 
  2001
  2002
  2003
 
Common stock:                
Beginning balance   $ 402   412   594  
  Issuance of Class A common stock, net of issuance expenses       144    
  Issuance of Class A common stock in stock option and warrant exercises     10   29   21  
  Issuance of Class A common stock on conversion of Series A and B preferred stock       9    
   
 
 
 
Ending balance     412   594   615  
   
 
 
 
Series A Convertible Preferred and Series B Preferred Stock:                
Beginning balance     1,149   1,220   1,249  
  Issuance of Series A convertible preferred stock as paid-in-kind dividend     71   74   77  
  Issuance of Series B preferred stock       1    
  Conversion of Series A and B preferred stock to Class A common stock       (46 )  
   
 
 
 
Ending balance     1,220   1,249   1,326  
   
 
 
 
Additional paid-in capital:                
Beginning balance     266,888   275,510   384,927  
  Issuance of Class A common stock, net of issuance expenses     1,070   96,336   471  
  Issuance of Class A common stock, in connection with employee stock purchase plan         592  
  Issuance of Series B preferred stock       (1 )  
  Issuance of Class A common stock on conversion of Series A and B preferred stock, net       37    
  Issuance of Series A convertible preferred stock as paid-in-kind dividend     6,979   7,410   7,584  
  Issuance and exercise of stock options and warrants     305   5,294   5,496  
  Tax benefit from employee stock options         6,600  
  Deferred compensation     268   341   287  
   
 
 
 
Ending balance     275,510   384,927   405,957  
   
 
 
 
Accumulated losses:                
Beginning balance     (234,470 ) (246,383 ) (214,135 )
  Net income (loss)     (4,862 ) 39,732   52,147  
  Convertible preferred stock paid-in-kind dividend     (7,051 ) (7,484 ) (7,661 )
   
 
 
 
Ending balance     (246,383 ) (214,135 ) (169,649 )
   
 
 
 
Treasury stock:                
Beginning balance     (102 ) (135 ) (3,539 )
  Purchases of Class A common stock     (33 ) (3,404 ) (3,204 )
   
 
 
 
Ending balance     (135 ) (3,539 ) (6,743 )
   
 
 
 
Accumulated other comprehensive income:                
Beginning balance     (5,274 ) (10,384 ) (326 )
  Other comprehensive income (loss)     (5,110 ) 10,058   5,972  
   
 
 
 
Ending balance     (10,384 ) (326 ) 5,646  
   
 
 
 
Total stockholders' equity   $ 20,240   168,770   237,152  
   
 
 
 
Comprehensive income (loss):                
Net income (loss)   $ (4,862 ) 39,732   52,147  
Other comprehensive income (loss):                
  Minimum pension liability adjustment     38   (2,261 ) (781 )
  Foreign currency translation adjustment     (296 ) 4,758   7,181  
  Cash flow hedges     (7,816 ) (1,193 ) (7,633 )
  Reclassification adjustments for losses reclassified into operations     2,962   8,654   6,314  
  Unrealized gain on investments     2   100   891  
   
 
 
 
Other comprehensive income (loss)     (5,110 ) 10,058   5,972  
   
 
 
 
Comprehensive income (loss)   $ (9,972 ) 49,790   58,119  
   
 
 
 

See accompanying notes to consolidated financial statements.

63


SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2001, 2002 and 2003
(in thousands)

 
  Years Ended December 31,
 
 
  2001
  2002
  2003
 
Cash flows from operating activities:                
  Net income (loss)   $ (4,862 ) 39,732   52,147  
   
 
 
 
  Adjustments to reconcile net income (loss) to cash provided by operating activities:                
      Depreciation and amortization     53,498   42,835   47,685  
      Change in deferred income taxes, net of effects of businesses acquired     4,177   (33,984 ) 19,954  
      Non-cash interest expense     2,435   2,298   2,415  
      Deferred finance fees—early extinguishment of debt       22,501   293  
      Changes in operating assets and liabilities, net of effects of acquisitions:                
        Accounts receivable     4,030   358   (27,802 )
        Inventories     7,707   8   (3,969 )
        Accounts payable     (533 ) (4,206 ) 6,911  
        Accrued liabilities     (5,620 ) (3,383 ) 22,159  
      Other     1,579   3,695   (4,792 )
   
 
 
 
        Total adjustments     67,273   30,122   62,854  
   
 
 
 
Net cash provided by operating activities     62,411   69,854   115,001  
   
 
 
 
Cash flows from investing activities:                
  Capital expenditures     (7,398 ) (15,880 ) (14,599 )
  Wagering systems expenditures     (39,095 ) (15,137 ) (21,009 )
  Change in other assets and liabilities     (9,591 ) (14,131 ) (41,454 )
  Business acquisitions, net of cash acquired       (4,104 ) (167,905 )
   
 
 
 
Net cash used in investing activities     (56,084 ) (49,252 ) (244,967 )
   
 
 
 
Cash flows from financing activities:                
  Net borrowings (repayments) under revolving credit facility     5,750   (14,750 )  
  Proceeds from issuance of long-term debt       291,335   463,548  
  Payments on long-term debt     (6,573 ) (357,463 ) (293,137 )
  Payment of financing fees       (17,531 ) (237 )
  Net proceeds from issuance of common stock     1,046   98,398   2,907  
   
 
 
 
Net cash provided by (used in) financing activities     223   (11 ) 173,081  
   
 
 
 
Effect of exchange rate changes on cash     (389 ) 1,689   1,329  
   
 
 
 
Increase in cash and cash equivalents     6,161   22,280   44,444  
Cash and cash equivalents, beginning of period     6,488   12,649   34,929  
   
 
 
 
Cash and cash equivalents, end of period   $ 12,649   34,929   79,373  
   
 
 
 

See accompanying notes to consolidated financial statements.

64


Non-cash investing and financing activities

        For the years ended December 31, 2001, 2002 and 2003

        See Notes 9 and 10 for a description of the write-off of deferred financing fees and capital lease transactions.

        Supplemental cash flow information

        Cash paid during the period for:

 
  Years Ended December 31,
 
  2001
  2002
  2003
Interest   $ 50,659   47,676   23,347
Income taxes, net of refunds   $ 300   3,707   7,693

Non-cash financing activity during the period:

 

 

 

 

 

 

 
  Convertible preferred stock paid-in-kind dividends   $ 7,051   7,484   7,661

See accompanying notes to consolidated financial statements.

65



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

(1)    Description of the Business and Summary of Significant Accounting Policies

(a) Description of the Business

        Scientific Games Corporation (the "Company") operates primarily in four business segments: Lottery Group, Pari-mutuel Group, Venue Management Group and Telecommunications Products Group.

        The Lottery Group encompasses the full range of lottery game consulting and production services, including the manufacturing, warehousing and distribution of instant lottery tickets and related instant ticket services such as game design, sales and marketing support, retailer telemarketing and field services. The Company also provides on-line lottery systems and systems-related services, including transaction processing software that accommodates instant ticket game accounting and validation and on-line lottery games, point-of-sale terminal hardware which connects to these systems, central site computer and communications hardware which runs these systems and ongoing maintenance for each of these items. The Company's lottery products and services are provided primarily to governmentally sanctioned lotteries worldwide.

        The Pari-mutuel Group includes all aspects of the Company's pari-mutuel service business, which encompass its North American and international on-track, off-track and inter-track pari-mutuel services, simulcasting and communications services, video gaming, and sales of pari-mutuel systems and equipment. The Company is a leading worldwide provider of computerized pari-mutuel wagering. The Company is one of the leading providers of simulcasting services to the racing industry in the United States and Europe.

        The Venue Management Group owns and operates off-track betting operations in Connecticut and is the exclusive licensed operator of all on-track and off-track pari-mutuel wagering operations in The Netherlands.

        The Telecommunications Products Group, through its United Kingdom based operations, incorporates its superior lottery derived proprietary technology to create and manufacture highly secure, paper-based, prepaid phone cards for the international cellular telephone markets.

(b) Principles of Consolidation

        The accompanying consolidated financial statements include the accounts of the Company and subsidiaries in which the Company's ownership is greater than 50%. Investments in other entities in which the Company has the ability to exercise significant influence over the investee are accounted for on the equity basis. Under the equity method, investments are stated at cost plus the Company's equity in undistributed earnings after acquisition. All significant inter-company balances and transactions have been eliminated in consolidation.

(c) Cash and Cash Equivalents

        The Company considers all highly liquid debt instruments with an original maturity at the date of purchase of three months or less to be cash equivalents.

66



(d) Inventories

        Inventories are stated at the lower of cost or market. Cost is determined as follows:

Item

  Cost method

Parts   First-in, first-out or weighted moving average.

Work-in-process and finished goods

 

First-in, first-out or weighted moving average for direct material and labor; other fixed and variable production costs are allocated as a percentage of direct labor cost.

        The Company adjusts inventory accounts on a periodic basis to reflect the impact of potential obsolescence.

(e) Property and Equipment

        Property and equipment are stated at cost. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the assets as follows:

Item

  Estimated Life
in Years

Machinery and equipment   3-10
Transportation equipment   3-7
Furniture and fixtures   5-10
Buildings and leasehold improvements   5-40

        Depreciation expense includes the amortization of capital leased assets. The Company typically depreciates the equipment and installation costs for new customers on a straight-line method over the life of the initial term of their contracts.

(f) Deferred Installation Costs

        Certain installation costs consisting of installation materials, customer contracted software and installation labor associated with leased systems are deferred and amortized over the lives of the leases unless such costs are reimbursed by the lessee, in which case such amounts are included in revenue and cost of sales. Deferred installation costs, net of accumulated depreciation, included in property and equipment were approximately $18,532 and $16,690 at December 31, 2002 and 2003, respectively.

(g) Goodwill and Acquired Intangible Assets

        Goodwill represents the excess of the purchase price over the fair value of the net assets of acquired companies. In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement No. 141, Business Combinations ("SFAS 141"), and Statement No. 142, Goodwill and Other Intangible Assets ("SFAS 142"), and in August 2001 the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after September 30, 2001.

67



SFAS 142 requires, commencing January 1, 2002, that all goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead, be evaluated for impairment on an annual basis. SFAS 144 requires that intangible assets with definite useful lives continue to be amortized over their useful lives, but be tested for impairment whenever events or changes in circumstances indicate that the carrying value of such asset may not be recoverable. The Company adopted these statements upon issuance, and accordingly all amortization related to goodwill and intangible assets with indefinite useful lives ceased as of January 1, 2002. The Company performs the impairment tests for goodwill and intangible assets with indefinite useful lives on an annual basis at the end of its fiscal year. (See Note 6.)

(h) Other Assets and Investments

        The Company capitalizes costs associated with internally developed and/or purchased software systems for new products and enhancements to existing products and for use in its wagering service contracts that meet technological feasibility and recoverability tests. The Company also capitalizes costs associated with the procurement of long-term financing, and costs attributable to transponder leases, patents, trademarks, marketing rights, and non-competition and employment agreements arising primarily from business acquisitions. These capitalized costs are amortized on the straight-line basis over their useful lives. The Company adopted the provisions of SFAS 141, SFAS 142 and SFAS 144 upon issuance by the FASB and has performed an evaluation of the assets that have been acquired in prior business combinations. Certain reclassifications have been made to comply with the provisions of such new FASB Statements. As a result, amortization of certain reclassified intangible assets has been ceased. In accordance with the new FASB Statements, an evaluation is performed to determine if any impairment has occurred with respect to any amortized or non-amortized assets. See Note 6 for further details relating to the amortization, reclassification, and impairment testing of all intangible assets.

(i) Impairment of Long-Lived Assets and Acquired Intangible Assets

        The Company assesses the recoverability of long-lived assets (excluding goodwill) and identifiable acquired intangible assets with finite useful lives, whenever events or changes in circumstances indicate that the carrying value of such an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the asset to the expected net future undiscounted cash flows to be generated by that asset, or, for identifiable intangibles with finite useful lives, by determining whether the amortization of the intangible asset balance over its remaining life can be recovered through undiscounted future cash flows. The amount of impairment of identifiable intangible assets with finite useful lives, if any, to be recognized is measured based on projected discounted future cash flows. The amount of impairment of other long-lived assets (excluding goodwill) is measured by the amount by which the carrying value of the asset exceeds the fair market value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair market value, less costs to sell.

(j) Revenue Recognition

        Revenues from pari-mutuel wagering services, on-line lottery systems services, cooperative services arrangements, certain instant ticket contracts and the operation of off-track betting venues are recognized

68



based on a percentage of amounts wagered pursuant to the terms of the contract. Simulcasting and telecommunication service revenue is recognized as services are performed. Costs incurred in connection with the manufacture, installation, and integration of terminals, software and telecommunications configurations are initially capitalized and amortized on a straight-line basis over the term of the contract. Costs of providing operating services are charged to operations in the period incurred. Revenues from sales of products including instant tickets, prepaid phone cards and stand alone terminals are recognized when shipped and the customer takes ownership and assumes risk of loss.

        Liquidated damages assessed by the customer prior to the activation of the wagering systems are recognized as a reduction of revenue over the contract period.

        Revenues from multiple element contracts for the sale of lottery and pari-mutuel wagering systems including the licensing of software, software maintenance and other services are recognized using the guidance from SOP 97-2, Software Revenue Recognition, as amended. Under multiple element arrangements, where each element is separately stated, sold and priced, the Company allocates revenues to the various elements based on vendor-specific objective evidence of fair value. If evidence of fair value does not exist for all elements in a multiple element arrangement, the Company recognizes revenue using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement is recognized as revenue.

        Revenues from major long term contracts for the sale of lottery and pari-mutuel wagering systems and revenues for contracted software development are recognized on the percentage of completion method of accounting based on the ratio of costs incurred to estimated costs to complete. Any anticipated losses on fixed price contracts are charged to operations when such losses can be estimated.

(k) Income Taxes

        Income taxes are calculated using the asset and liability method under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"). Under this method, deferred income taxes are calculated by applying enacted statutory tax rates to cumulative temporary differences between financial statement carrying amounts and the tax basis of existing assets and liabilities. Under SFAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

(l) Foreign Currency Translation

        Assets and liabilities of foreign operations are translated at year-end rates of exchange and operations are translated at the average rates of exchange for the year. Gains or losses resulting from translating the foreign currency financial statements are accumulated as a separate component of accumulated other comprehensive income (loss) in stockholders' equity. Gains or losses resulting from foreign currency transactions are included in other income (expense) in the consolidated statements of operations.

69


(m) Stock-Based Compensation

        In December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123 ("SFAS 148"). SFAS 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation ("SFAS 123"), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. However, it allows an entity to continue to measure compensation cost for those instruments using the intrinsic-value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), provided it discloses the effect of SFAS 123, as amended by SFAS 148, in footnotes to the financial statements. The Company has chosen to continue to account for stock-based compensation using the intrinsic-value-based method. Accordingly, no stock option related compensation expense has been recognized for a substantial majority of its stock-based compensation plans. The Company was required to adopt SFAS 148 for the year ended December 31, 2002. The adoption of SFAS 148 did not have an impact on the consolidated results of operations or financial position of the Company for fiscal 2002 and 2003.

        Had the Company, however, elected to recognize compensation cost based on fair value of the stock options at the date of grant under SFAS 123, as amended by SFAS 148, such costs would have been recognized ratably over the vesting period of the underlying instruments and the Company's net income (loss) and net income (loss) per share would have changed to the pro forma amounts indicated in the table below.

        Pro forma net income (loss) and income (loss) per basic and diluted share were:

 
  Year Ended December 31,
 
 
  2001
  2002
  2003
 
Net income (loss) available to common stockholders, as reported   $ (11,913 ) 32,248   44,486  
Add: Stock-based compensation expense included in reported net income, net of related tax effects         187  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (1)     (2,611 ) (2,630 ) (3,850 )
   
 
 
 
Pro forma net income (loss) available to common stockholders   $ (14,524 ) 29,618   40,823  
   
 
 
 

Net income (loss) available to common stockholders per basic share:

 

 

 

 

 

 

 

 
  As reported   $ (0.30 ) 0.64   0.74  
   
 
 
 
  Pro forma   $ (0.36 ) 0.59   0.72  
   
 
 
 
Net income (loss) available to common stockholders per diluted share:                
  As reported   $ (0.30 ) 0.50   0.59  
   
 
 
 
  Pro forma   $ (0.36 ) 0.46   0.57  
   
 
 
 

(1)
The amounts for years 2002 and 2003 are net of income tax benefit. No adjustments were made for income tax benefit in year 2001 as the Company had only recognized tax benefits of prior period operating losses to the extent such losses would be offset by net taxable temporary differences expected to reverse during the carryforward period.

70


        The fair value of the options granted was estimated using the Black-Scholes option-pricing model based on the weighted average market price at date of grant of $4.72 in fiscal 2001, $6.75 in fiscal 2002 and $11.21 in 2003 and the following assumptions: risk-free interest rate of 4.9% for fiscal 2001, 4.2% for fiscal 2002 and 3.3% for fiscal 2003; expected option life of 7.0 years for fiscal 2001, 2002 and 2003; expected volatility of 76% for fiscal 2001, 74% for fiscal 2002 and 72% for fiscal 2003; and no dividend yield in any year. The average fair values of options granted during fiscal years 2001, 2002, and 2003 were $3.48, $4.82 and $7.68, respectively.

(n) Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Some of the significant estimates involve percentage of completion for contracted lottery development projects and pari-mutuel systems software development projects, capitalization of software development costs, evaluation of the recoverability of assets and assessment of litigation and contingencies, and income and other taxes. Actual results could differ from estimates.

(o) Comprehensive Income (Loss)

        Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"), establishes standards for the reporting and display of comprehensive income (loss) and its components in a full set of financial statements. SFAS 130 requires that unrealized losses from the Company's foreign currency translation adjustments, interest rate derivatives, unrecognized minimum pension liability and unrealized gains (losses) on investments be included in other comprehensive income (loss).

(p) Derivative Instruments and Hedging Activities

        Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"), Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activity, an Amendment of SFAS 133 ("SFAS 138") and Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities ("SFAS 149"), require that all derivative instruments be recorded on the balance sheet at their respective fair values.

        The Company has several derivative contracts to hedge part of the Company's foreign currency exposure with respect to future cash receipts under a contract with the Ontario Lottery Commission. These derivative instruments have been designated as cash flow hedges and recorded on the balance sheet at their respective fair values as prescribed by SFAS 133, SFAS 138 and SFAS 149.

        All derivatives are recognized on the balance sheet at their fair value. On the date the derivative contract is entered into, the Company designates the derivative as a hedge of the variability of cash flows to be paid or received related to its long-term debt obligation or customer contract, respectively ("cash flow"). The Company formally documents all relationships between hedging instruments and

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hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash-flow hedges to specific components of its long-term obligations and contract cash receipts. The Company also formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively.

        Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash-flow hedge are recorded in other comprehensive income (loss), until operations are affected by the variability in cash flows of the designated hedge item. Changes in the fair value of derivative trading instruments are reported in current-period operations.

        The Company discontinues hedge accounting prospectively when it determines that the derivative is no longer effective in offsetting changes in cash flows of the hedged item, the derivative expires or is sold, terminated, or exercised. When hedge accounting is discontinued, the Company continues to carry the derivative at its fair value on the consolidated balance sheet, and recognizes any changes in its fair value in operations.

(q) Reclassification to Prior Years' Consolidated Financial Statements

        Effective January 1, 2003, the Company adopted FASB Statement No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds Statement No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect, and requires the criteria in Accounting Principles Board Opinion No. 30 to be used to classify gains and losses. Accordingly, the Company has reclassified the extraordinary losses incurred in 2002 to other deductions-early extinguishment of debt. These debt extinguishments totaled $22,501 of pre-tax expense in 2002. Certain other reclassifications have been made to the prior years' consolidated financial statements to conform to the current presentation.

(2)    Basic Income (Loss) Per Common Share and Diluted Income (Loss) Per Common Share

        Basic income (loss) per common share is computed by dividing income (loss) by the weighted average number of common shares outstanding during the period. Diluted income per common share gives effect to all dilutive potential common shares that were outstanding during the period. At December 31, 2003, the Company had outstanding stock options, warrants, Performance Accelerated Restricted Stock Units (representing shares of deferred stock), and Series A Convertible Preferred Stock, which could potentially dilute basic earnings per share in the future (see Notes 12 and 13).

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        The following represents a reconciliation of the numerator and denominator used in computing basic and diluted income (loss) available to common stockholders per common share for the years ended December 31, 2001, 2002 and 2003:

 
  Years Ended December 31,
 
  2001
  2002
  2003
Income (loss) (numerator)              
Net income (loss) available to common stockholders   $ (11,913 ) 32,248   44,486
Add back preferred stock paid-in-kind dividend (1)       7,484   7,661
   
 
 
Income (loss) before preferred stock dividend available to common stockholders (diluted)   $ (11,913 ) 39,732   52,147
   
 
 
Shares (denominator)              
Basic weighted average common shares outstanding     40,340   50,221   60,010
Effect of diluted securities—stock options, convertible preferred shares and deferred shares(2)       29,930   28,133
   
 
 
Diluted weighted average common shares outstanding     40,340   80,151   88,143
   
 
 
Basic and Diluted per share amounts              
Basic net income (loss) available to common stockholders   $ (0.30 ) 0.64   0.74
   
 
 
Diluted net income (loss) available to common stockholders   $ (0.30 ) 0.50   0.59
   
 
 

(1)
Series A Convertible Preferred Stock paid-in-kind dividend is not added back in the calculation of diluted net income per share in the year ended December 31, 2001 since assuming conversion of the preferred shares would be anti-dilutive.

(2)
Potential common shares are not included in the calculation of dilutive net loss per share for the year ended December 31, 2001 since inclusion would be anti-dilutive.

(3)    Acquisitions

        On November 6, 2003, the Company acquired IGT OnLine Entertainment Systems, Inc. ("OES") from International Game Technology (NYSE: IGT) for $143,000 in cash plus expenses and an estimated $7,000 working capital payment, subject to closing adjustments. Upon consummation of the acquisition, the Company changed the name of IGT OnLine Entertainment Systems, Inc. to Scientific Games Online Entertainment Systems, Inc. The results of OES have been included in the Company's results of operations from the date of acquisition. In its most recent fiscal year, OES had annual revenues of approximately $148,818.

        The acquisition of OES strengthens the Company's presence in the lottery industry, expands the Company's geographic presence, broadens its lottery product offerings and accelerates its entrance into the video lottery systems business. As a result of the acquisition, the Company has contracts to operate on-line lottery systems in 16 states and throughout the Caribbean, in addition to supporting systems that OES delivered to customers in Korea, Norway, Switzerland and Shanghai. The acquisition also

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included OES's Advanced Gaming System (AGS) video system contracts in six jurisdictions throughout the world, certain intellectual property and an exclusive license to specific IGT slot brands for both instant and on-line games. The Company is in the process of allocating the purchase price of OES, including performing a thorough analysis to estimate the fair value of the assets acquired and liabilities assumed, and it expects that a majority of the excess will be allocated to goodwill. Goodwill from the acquisition of OES will be deductible for tax purposes.

        In connection with the acquisition of OES, on November 6, 2003 the Company amended and restated its senior secured credit facility (as amended and restated, the "2003 Facility") to (a) permit the OES acquisition and related incurrence of indebtedness, (b) increase the revolving credit facility by $25,000 to $75,000, (c) enter into a $462,825 Term C Loan, of which $287,825 was used to repay in full the existing Term B Loan, $143,000 was used to pay the purchase price for the OES acquisition and the balance is available for general corporate purposes, and (d) make certain other changes to the credit agreement governing the 2002 Facility (such agreement, the "Credit Agreement"). The Term C Loan carries interest at the Base Rate plus a margin of 1.75% per annum, or at the rate of LIBOR plus a margin of 2.75% per annum, with the provision that when the Consolidated Leverage Ratio is less than 2.00:1.00 then the Base Rate margin and the LIBOR margin drop to 1.50% and 2.50%, respectively. The Term C Loan matures in December 2009 and requires quarterly principal payments of $1,157 through December 31, 2008 plus four quarterly principle payments of $109,921 in 2009.

        The following table presents the unaudited condensed balance sheet of OES at the November 6, 2003 acquisition date, adjusted for the preliminary allocation of the purchase price to the assets acquired. This preliminary purchase price allocation is subject to revisions until the valuation of OES's assets and liabilities is finalized.

 
  November 6,
2003

 
  (unaudited)

Assets:      
  Cash, cash equivalents and other current assets   $ 28,673
  Property and equipment     24,869
  Goodwill     102,232
  Acquired customer service contracts     31,000
  Other long-term assets     1,397
   
    Total assets   $ 188,171
   
Liabilities and Stockholder's Equity:      
  Current liabilities     29,004
  Long-term liabilities     6,123
  Stockholder's equity     153,044
   
    Total liabilities and stockholder's equity   $ 188,171
   

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        The following table presents unaudited pro forma results of operations as if the acquisition of OES had occurred at the beginning of the periods presented. These pro forma results have been prepared for comparative purposes and do not purport to be indicative of what would have occurred had the acquisition been made at the beginning of the Company's fiscal years ended December 31, 2002 and 2003, or the results that may occur in the future.

 
  Years Ended December 31,
 
  2002 (1)
  2003 (2)
 
  (unaudited)

Operating revenues   $ 598,559   687,961
Operating income     97,186   127,980
Income before income tax expense     20,990   92,351
Net income     44,322   56,986
Convertible preferred stock dividend     7,484   7,661
   
 
Net income available to common stockholders   $ 36,838   49,325
   
 
Basic net income per share available to common stockholders   $ 0.73   0.82
   
 
Diluted net income per share available to common stockholders   $ 0.55   0.65
   
 

(1)
The amounts in this column represent the pro forma results of operations for Scientific Games for the year ended December 31, 2002 and for OES for the twelve months ended December 28, 2002. OES amounts were derived from the reported historical combined financial statements of OES as follows: the unaudited results of operations for the nine months ended September 28, 2002 were added to the unaudited results of operations for the nine months ended June 28, 2003, less the unaudited results of operations for the six months ended June 28, 2003.

(2)
The amounts in this column represent the pro forma results of operations of Scientific Games without OES for the year ended December 31, 2003 and OES for the twelve months ended September 27, 2003.

        On January 17, 2003, the Company completed the acquisition of MDI Entertainment, Inc. ("MDI") through (i) a tender offer at $1.60 per share, in cash, (ii) the purchase of shares from MDI's President and Chief Executive Officer pursuant to a separate stock purchase agreement and (iii) a merger agreement, whereby the remaining eight percent of MDI common shares were converted into the right to receive $1.60 per share in cash. With the purchase of MDI, the Company significantly expanded its offerings of licensed branded products and prize fulfillment and related services. MDI has been successful in helping lotteries attract players to new kinds of tickets and second chance games that allow players to win merchandise, such as Harley Davidson motorcycles and trips and prizes like tickets to NBA playoff games. The Company's portfolio of licensed brands now includes Hasbro®, Mandalay Bay®, NBA®, Harley-Davidson® and Wheel-of-Fortune®, to name a few. The exclusive licenses from Hasbro include Monopoly®, Battleship® and Scrabble®. The Company expects that its acquisition of MDI will enable it to further expand the use of branded games and prize fulfillment services to continue to help its customers generate revenues to meet the needs of their beneficiaries. The acquisition was recorded using the purchase method of accounting. The excess of the $22,958 purchase

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price over the fair values of the net assets acquired is approximately $22,213 and has been recorded as goodwill. The operating results of MDI have been included in the Company's consolidated operating results since the date of acquisition. Had the operating results of MDI been included as if the transaction had been consummated on January 1, 2003, the Company's pro forma operating results for the year ended December 31, 2003 would not have been materially different from the actual reported results. Goodwill from the acquisition of MDI is not deductible for tax purposes.

        On June 5, 2002, the Company completed the purchase of 65% of the equity of Serigrafica Chilena S.A. ("SERCHI"). Subsequent to the acquisition, the Company changed the name of SERCHI to Scientific Games Latino America S.A. The purchase price was approximately $3,900 in cash and up to $4,355 in cash or stock payable to SERCHI stockholders upon the achievement of certain financial performance levels of SERCHI over the next four years. In 2003, the Company made a cash payment of $915 due to the achievement of certain financial performance levels in 2002. The acquisition has been accounted for using the purchase method of accounting and the acquired assets and liabilities have been recorded at their estimated fair values at the date of acquisition. The excess of the purchase price over the fair values of the net assets acquired is approximately $3,751 and has been recorded as goodwill. The operating results of the SERCHI business have been included in the consolidated statements of operations since the date of acquisition. Had the operating results of SERCHI been included as if the transaction had been consummated on January 1, 2002, the pro forma operating results of the Company for the year ended December 31, 2002 would not have been materially different. Goodwill from the SERCHI purchase is not deductible for tax purposes.

(4)    Inventories

        Inventories consist of the following:

 
  December 31,
 
  2002
  2003
Parts and work-in-process   $ 10,850   17,990
Finished goods     9,685   8,906
   
 
    $ 20,535   26,896
   
 

        Point of sale terminals manufactured by the Company may be sold to customers or included as part of a long-term wagering system contract. Parts and work-in-process includes costs for equipment expected to be sold. Costs incurred for equipment associated with specific wagering system contracts not yet placed in service are classified as construction in progress in property and equipment (see Note 5).

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(5)    Property and Equipment

        Property and equipment, including assets under capital leases, consist of the following:

 
  December 31,
 
 
  2002
  2003
 
Machinery, equipment and deferred installation costs   $ 311,785   355,680  
Land and buildings     49,990   49,135  
Transportation equipment     4,362   4,800  
Furniture and fixtures     10,995   13,025  
Leasehold improvements     14,515   18,013  
Construction in progress     13,038   32,957  
   
 
 
  Property and equipment, at cost     404,685   473,610  
Less: Accumulated depreciation     (203,819 ) (244,880 )
   
 
 
  Net property and equipment   $ 200,866   228,730  
   
 
 

        Depreciation expense for the years ended December 31, 2001, 2002 and 2003 amounted to $32,919, $35,009 and $36,768, respectively.

        Cost for equipment associated with specific wagering systems contracts not yet placed in service are recorded as construction in progress. When the equipment is placed in service at wagering facilities, the related costs are transferred from construction in progress to machinery and equipment, and the Company commences depreciation.

(6)    Goodwill and Intangible Assets, Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of

        The Financial Accounting Standards Board ("FASB") SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets ("SFAS 142"), require companies to cease amortizing goodwill that existed at June 30, 2001 on December 31, 2001. Any goodwill resulting from acquisitions completed after June 30, 2001 will not be amortized. SFAS No. 142 also broadens the criteria for recording intangible assets separate from goodwill and establishes a new method of testing goodwill impairment whereby goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value.

        In connection with the adoption of SFAS 142, the Company evaluated its intangible assets and determined that its right to operate off-track betting in Connecticut and its trade name which had net carrying amounts of approximately $11,681 and $30,082, respectively, at December 31, 2001, have indefinite useful lives and, accordingly, the Company ceased amortization as of January 1, 2002. In addition, as required by SFAS 142, the Company reclassified its employee work force intangible asset with a net carrying value of approximately $3,170, net of related deferred tax liabilities of $2,113, to goodwill effective January 1, 2002. Amortization expense of these intangible assets and goodwill was approximately $16,909 for the year ended December 31, 2001. As a result of adoption of SFAS 142, the Company also reduced the recognized amount of its net operating loss carryforward ("NOL") from $18,520 to $8,730 to reflect the reduction in the amount of the net taxable temporary differences that are expected to reverse during the loss carryforward period because of the cessation of amortization of the tradename and employee workforce intangible assets. This NOL reduction was charged to income tax expense in the first quarter of 2002.

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        The following disclosure presents certain information on the Company's acquired intangible assets as of December 31, 2002 and 2003. Amortized intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values.

Intangible Assets

  Weighted
Average
Amortization
Period

  Gross
Carrying
Amount

  Accumulated
Amortization

  Net
Balance

Balance at December 31, 2002                  
Amortizable intangible assets:                  
  Patents   15   $ 1,084   163   921
  Customer lists   14     14,600   4,089   10,511
  Customer service contracts   15     3,341   1,053   2,288
       
 
 
          19,025   5,305   13,720
       
 
 
Non-amortizable intangible assets:                  
  Trade name         32,200   2,118   30,082
  Connecticut off-track betting system operating right         22,339   8,319   14,020
       
 
 
          54,539   10,437   44,102
       
 
 
Total intangible assets       $ 73,564   15,742   57,822
       
 
 
Balance at December 31, 2003                  
Amortizable intangible assets:                  
  Patents   15   $ 3,139   291   2,848
  Customer lists   14     15,375   5,984   9,391
  Customer service contracts   15     3,781   1,280   2,501
  Licenses   1-15     3,928   1,136   2,792
  Lottery contracts   1-7.5     31,000   1,186   29,814
       
 
 
          57,223   9,877   47,346
       
 
 
Non-amortizable intangible assets:                  
  Trade name         32,200   2,118   30,082
  Connecticut off-track betting system operating right         22,339   8,319   14,020
       
 
 
          54,539   10,437   44,102
       
 
 
Total intangible assets       $ 111,762   20,314   91,448
       
 
 

        The aggregate intangible amortization expense for the years ended December 31, 2001, 2002 and 2003 was approximately $6,759, $2,035 and $4,572, respectively. The estimated intangible asset amortization expenses for the year ending December 31, 2004 and for each of the subsequent four years, ending December 31, 2008, are approximately $10,636, $8,985, $7,618, $6,612 and $5,205, respectively.

        The table below reconciles the change in the carrying amount of goodwill, by reporting unit, which is the same as operating segment, for the period from December 31, 2002 to December 31, 2003. The

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Company recorded a $915 increase in goodwill in 2003 in connection with an earnout payment pursuant to the SERCHI purchase agreement. Goodwill in the amount of $775, which was directly related to the value of customer service contracts acquired as part of the June 5, 2002 acquisition of 65% of the issued and outstanding shares of SERCHI, was reclassified to intangible assets effective January 2003 as a result of the completion of the final purchase price valuation and allocation during the first quarter of 2003. The Company recorded an increase to goodwill of $22,213 related to the final purchase price allocation of MDI. The Company recorded an increase to goodwill of $102,232 related to the preliminary purchase price allocation of OES, subject to revision pending the completion of the final valuation and allocation of the purchase price.

Goodwill

  Lottery
Group

  Pari-Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
 
Balance at December 31, 2001   $ 176,502   2,597       179,099  
Effect of adoption of SFAS 141 and SFAS 142:                        
  Reclassification of employee workforce intangible asset, net of tax     3,170         3,170  
  Reclassification of customer service contract to intangible assets       (2,110 )     (2,110 )
  Acquisition of a majority interest in SERCHI     3,611         3,611  
   
 
 
 
 
 
Balance at December 31, 2002     183,283   487       183,770  
  SERCHI earnout payment     915         915  
  Reclassification of SERCHI customer service contract intangible asset     (775 )       (775 )
  Acquisition of MDI     22,213         22,213  
  Acquisition of OES     102,232         102,232  
   
 
 
 
 
 
Balance at December 31, 2003   $ 307,868   487       308,355  
   
 
 
 
 
 

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        The following table compares pro forma net income (loss) available to common stockholders for the years ended December 31, 2001, 2002 and 2003, adjusted to reflect the adoption of SFAS 142 on November 1, 1999, to the reported net income for the year ended December 31, 2003:

 
  Years Ended December 31,
 
  2001
  2002
  2003
 
  Pro Forma

  As Reported

  As Reported

Adjusted income available to common stockholders:              
Adjusted income   $ 5,251   39,732   52,147
   
 
 
Adjusted net income (loss) available to common stockholders   $ (1,800 ) 32,248   44,486
   
 
 
Adjusted earnings per share amounts—basic and diluted:              
Adjusted net income (loss) per share available to common stockholders:              
  Basic   $ (0.04 ) 0.64   0.74
   
 
 
  Diluted   $ (0.04 ) 0.50   0.59
   
 
 
Shares used in calculating adjusted per share amounts:              
  Basic     40,340   50,221   60,010
   
 
 
  Diluted     40,340   80,151   88,143
   
 
 
Reconciliation of reported net income to adjusted net income (loss):              
  Reported net income (loss) available to common stockholders   $ (11,913 ) 32,248   44,486
  Add back:              
  Amortization of goodwill and intangible assets with indefinite lives, net of tax benefit     10,113    
   
 
 
  Adjusted net income (loss) available to common stockholders   $ (1,800 ) 32,248   44,486
   
 
 

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(7)    Other Assets and Investments

        Other assets and investments, (net) consist of the following:

 
  December 31,
 
  2002
  2003
Software systems development costs   $ 28,736   33,401
Deferred financing costs     7,786   10,834
Deferred tax asset     12,109   14,409
SERP trust       14,897
Other assets     14,322   23,550
   
 
    $ 62,953   97,091
   
 

        In the years ended December 31, 2002 and 2003, the Company capitalized $9,194 and $10,985, respectively, of software systems development costs related primarily to lottery and pari-mutuel wagering systems and video gaming. Capitalized costs are amortized on a straight-line basis over a period of five to ten years.

        Deferred financing costs arise in connection with the procurement of long-term financing by the Company, and are amortized over the life of the financing agreements. In fiscal 2002, the Company capitalized $5,374 in connection with replacing its 2000 senior secured credit facility (the "2000 Facility") with a new senior secured credit facility (the "2002 Facility") and wrote-off, as early extinguishment of debt, $10,226 of previously deferred financing costs in connection with its refinancing of the 2000 Facility and the redemption of approximately $82,957 of the Company's 121/2% Senior Subordinated Notes. In fiscal 2003 the Company capitalized $5,504 in connection with amending and restating the 2002 Facility. Amortization of deferred financing costs amounted to $2,435, $2,261 and $2,456 for the years ended December 31, 2001, 2002 and 2003, respectively.

        In 2003, the Company made an initial $14,700 cash payment to a rabbi trust, to provide for the payment of certain benefits under the Company's Supplemental Executive Retirement Plan (the "SERP"). The rabbi trust then made a $4,900 payment for whole-life insurance policies on the participants. These policies have been placed in the rabbi trust, which will hold the policies and death benefits as they are received. The cash value of these policies was approximately $5,095 at December 31, 2003.

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(8)    Accrued Liabilities

        Accrued liabilities consist of the following:

 
  December 31,
 
  2002
  2003
Compensation and benefits   $ 20,393   30,364
Customer advances     8,376   6,121
Deferred revenue     97   7,720
Accrued income taxes     2,418   7,328
Taxes, other than income     2,625   5,001
Accrued acquisition costs       11,037
Accrued contract costs     1,826   19,985
Other     17,778   25,705
   
 
    $ 53,513   113,261
   
 

(9)    Long-Term Debt

        Long-term debt consists of the following:

 
  December 31,
 
  2002
  2003
121/2% Series B Senior Subordinated Notes due 2010   $ 67,043   65,584
2002 Term B loan with varying interest rate due 2008     290,000  
2003 Term C loan with varying interest rate due 2009       462,825
Capital lease obligations, payable monthly through
October 2005, interest from 5.1% to 12.1%
    567   988
Various loans and bank facilities, interest from 4.0% to 15.1%     2,919   2,766
   
 
  Total long-term debt     360,529   532,163
  Less current installments     3,865   6,327
   
 
  Long-term debt, excluding current installments   $ 356,664   525,836
   
 
 
  Debt and Capital Lease Payments Due by Period
 
  Total
  Within 1
Year

  Within 2 Years
  Within 3 Years
  Within 4 Years
  Within 5 years
  After 5
Years

Long-term debt, 121/2% Notes and 2003 Facility   $ 528,409   4,628   4,628   4,628   4,628   4,628   505,269
Other long-term debt     3,754   1,699   581   428   368   132   546
   
 
 
 
 
 
 
Total   $ 532,163   6,327   5,209   5,056   4,996   4,760   505,815
   
 
 
 
 
 
 

        At December 31, 2003, the Company had approximately $27,146 available for borrowing under the Company's revolving credit facility under the 2003 Facility. There were no borrowings outstanding under the 2003 Facility, but approximately $47,854 in letters of credit were issued under the facility at December 31, 2003. At December 31, 2002, the Company's available borrowing capacity under the 2002 Facility was $28,171. At December 31, 2003, there was $462,825 outstanding under the Term C Loan

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under the 2003 Facility, and $65,584 of the Company's 121/2% Senior Subordinated Notes (the "Notes") were outstanding. The average interest rate on Term C Loan for the period from the November 6, 2003 inception of the loan to December 31, 2003 was 4.11%.

        On November 6, 2003, the Company entered into the 2003 Facility by amending and restating the 2002 Facility to (a) permit the OES acquisition and related incurrence of indebtedness, (b) increase the revolving credit facility by $25,000 to $75,000, (c) enter into a $462,825 Term C Loan of which $287,825 was used to repay in full the existing Term B Loan, $143,000 was used to pay the purchase price for the OES acquisition and the balance is available for general corporate purposes, and (d) make certain other changes to the Credit Agreement. The Term C Loan carries interest at the Base Rate plus a margin of 1.75% per annum, or at the rate of LIBOR plus a margin of 2.75% per annum, with the provision that when the Consolidated Leverage Ratio is less than 2.00:1.00 then the Base Rate margin and the LIBOR margin drop to 1.50% and 2.50%, respectively. The Term C Loan matures in December 2009 and requires quarterly principal payments of $1,157 through December 31, 2008 plus four quarterly principal payments of $109,921 in 2009. The 2003 Facility is secured by a first priority, perfected lien on: (i) substantially all the property and assets (real and personal, tangible and intangible) of the Company and its wholly-owned domestic subsidiaries; (ii) 100% of the capital stock of all of the direct and indirect wholly-owned domestic subsidiaries and 65% of the capital stock of all of the wholly-owned first-tier foreign subsidiaries of the Company; and (iii) all inter-company indebtedness owing between the Company and its wholly-owned domestic subsidiaries. The 2003 Facility is supported by guarantees provided by all of the Company's direct and indirect wholly-owned domestic subsidiaries.

        In addition, the 2003 Facility is subject to the following mandatory prepayments, with certain customary exceptions: (i) 50% of the net cash proceeds from the sale or issuance of equity; (ii) 100% of the net cash proceeds from the sale or issuance of debt securities; (iii) 100% of the net proceeds from the sale of assets and casualty insurance proceeds, subject to a reinvestment exclusion limited to $20,000 per annum; and (iv) 50% of the Company's excess cash flow (as defined in the credit agreement governing the 2003 Facility), or 0% if the leverage ratio is less than 2.50 to 1.00.

        The Credit Agreement as amended and restated in connection with the 2003 Facility (as so amended and restated, the "Amended Credit Agreement") contains certain covenants that, among other things, limit the Company's ability, and the ability of certain of the Company's subsidiaries, to incur additional indebtedness, pay dividends or make distributions or certain other restricted payments, purchase or redeem capital stock, make investments or extend credit, engage in certain transactions with affiliates, engage in sale leaseback transactions, consummate certain asset sales, effect a consolidation or merger, sell, transfer, lease or otherwise dispose of all or substantially all assets, or create certain liens and other encumbrances on assets. Additionally, the Amended Credit Agreement contains the following financial covenants that are computed quarterly on a rolling four-quarter basis as applicable:

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        For purposes of the foregoing limitations, Consolidated EBITDA means the sum of (i) consolidated net income, (ii) consolidated interest expense with respect to all outstanding indebtedness, (iii) provisions for taxes based on income, (iv) total depreciation expense, (v) total amortization expense and (vi) certain adjustments, in each case for the period being measured, all of the foregoing as determined on a consolidated basis for the Company and its subsidiaries in accordance with GAAP.

        The Company was in compliance with these covenants for years 2002 and 2003.

        On December 19, 2002, the Company entered into the 2002 Facility and refinanced all of the then outstanding obligations under the existing 2000 Facility. The 2002 Facility consisted of: (a) a $50,000 revolving credit facility available for working capital and general corporate purpose loans and for letters of credit (the "2002 Revolver"), which would have matured in September 2006 with interest at the Base Rate (as defined in the credit agreement governing the 2002 Facility) plus a margin of 1.75% per annum, or at the rate of LIBOR plus a margin of 2.75% per annum, plus a commitment fee on the unused portion of 0.05% per annum, for the first six months and thereafter as determined by reference to a leverage-based pricing grid and (b) a $290,000 term loan (the "2002 Term B Loan") which would have matured in December 2008 with interest at the Base Rate plus a margin of 2.50% per annum, or at the rate of LIBOR plus 3.50% per annum.

        At December 31, 2002, available borrowing capacity under the 2002 Revolver was $28,171, net of outstanding letters of credit of $21,829. As of December 31, 2002, $290,000 of the 2002 Term B Loan

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and $67,043 of the 121/2% Senior Subordinated Notes were outstanding. The interest rate on the 2002 Term B Loan was 4.92% per annum.

        The 2002 Term B Loan required quarterly principal payments of $725 through December 31, 2007 and $68,875 in 2008. In addition, the 2002 Facility will be subject to the following mandatory prepayments, with certain customary exceptions: (i) 50% of the net cash proceeds from the sale or issuance of equity, (ii) 100% of the net cash proceeds from the sale or issuance of debt securities; (iii) 100% of the net proceeds from the sale of assets and casualty insurance proceeds, subject to a reinvestment exclusion limited to $20,000 per annum, and (iv) 50% of the Company's excess cash flow (as defined in the credit agreement governing the 2002 Facility), or 0% if the leverage ratio is less than 2.50 to 1.00.

        The 121/2% Senior Subordinated Notes due 2010 (the "Notes") bear interest at the rate of 121/2% per annum payable semi-annually on each February 15 and August 15, commencing February 15, 2001. The Notes are senior subordinated, unsecured obligations of the Company, ranking junior to all existing and future senior debt including obligations under the 2003 Facility. The Notes are fully and unconditionally guaranteed on a senior subordinated basis by all of the Company's wholly-owned U.S. subsidiaries (see Note 23). The Notes will be redeemable, at the option of the Company, at any time on or after August 15, 2005, in whole or in part, at redemption prices equal to 106.250%, 104.167%, 102.083% and 100.000% of the principal amount thereof if redeemed during the 12-month periods commencing on August 15 of years 2005, 2006, 2007, and 2008 and thereafter, respectively. The Notes mature August 15, 2010. The indenture governing the Notes contains certain covenants that, among other things, limit the Company's ability, and the ability of certain of the Company's subsidiaries, to incur additional indebtedness, pay dividends or make distributions or certain other restricted payments, purchase or redeem capital stock, make investments or extend credit, engage in certain transactions with affiliates, engage in sale leaseback transactions, consummate certain assets sales, effect a consolidation or merger, or sell, transfer, lease or otherwise dispose of all or substantially all assets, or create certain liens and other encumbrances on new assets.

        In the third quarter of 2002, the Company sold 14,375 shares of its Class A Common Stock (the "2002 Offering") and used the net proceeds to redeem approximately $82,957 of the Notes. In connection with this redemption, the Company paid the noteholders redemption premiums aggregating approximately $11,172 and paid the term loan lenders and banks related fees of approximately $1,103 to amend the 2000 Facility to permit the Company to use the majority of the net proceeds from the 2002 Offering to redeem the subordinated debt rather than pay down the 2000 Facility. In November 2002, the Company used approximately $1,741 of the remaining proceeds of the 2002 Offering to make mandatory repayments of the 2000 Term A and 2000 Term B Loans. Following the mandatory repayment of the 2000 Facility, there was $50,022 outstanding under the 2000 Term A Loans and $214,837 outstanding under the 2000 Term B Loans.

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(10)    Leases

        At December 31, 2003, the Company was obligated under operating leases covering office equipment, office and warehouse space, transponders and transportation equipment expiring at various dates through 2008. Future minimum lease payments required under these leasing arrangements at December 31, 2003 are as follows: $16,423 in 2004; $14,149 in 2005; $6,646 in 2006; $5,919 in 2007; $5,064 in 2008 and thereafter $10,813. Total rental expense under these operating leases was $10,941, $11,168 and $12,214 in the years ended December 31, 2001, 2002 and 2003, respectively.

        The Company acquired $723 of capitalized leases with the acquisition of OES in November 2003 and $805 of capitalized leases with the acquisition of 65% of the equity of SERCHI in June 2002.

(11)    Fair Value of Financial Instruments

        The fair value of financial instruments is determined by reference to market data and other valuation techniques as appropriate. The Company believes the fair value of its financial instruments, principally cash and cash equivalents, accounts receivable, other current assets, accounts payable, cash flow hedges and accrued liabilities approximates their recorded values.

        The Company believes that the fair value of the Notes approximated $77,770 and $77,553 at December 31, 2002 and 2003, respectively, based on reference to dealer markets and global market prices. The 2002 Term B Loan under the 2002 Facility was repaid in November 2003 with the proceeds of the 2003 Term C Loan. The Company believes that the fair value of the 2003 Term C Loan approximated $463,404 at December 31, 2003 based on the variable nature of the interest rates (see Note 9). The 2002 Term B Loan and the 2002 Facility borrowings had approximated their recorded values, respectively, based on their respective variable rates and currently available terms and conditions for similar debt at December 31, 2002.

(12)    Stockholders' Equity

Preferred Stock

        The Company has a total of 2,000 shares of preferred stock, $1.00 par value, authorized for issuance, including 1,600 authorized shares of Series A Preferred Stock.

        On November 19, 2003, SGMS Acquisition Corporation, the designee of its parent Mafco Holdings Inc. ("Mafco"), a privately held diversified holding company whose sole stockholder is Ronald O. Perelman and which has interests in consumer products, entertainment, financial services and other industries, acquired Cirmatica Gaming, S.A.'s entire equity interest in the Company, consisting of Series A Preferred Stock and Series B Preferred Stock and representing approximately 23% of the equity and voting power of the Company on an as-converted basis.

        The Series A Preferred Stock is convertible into the Company's common stock at prices of: (a) $4.63 per share if the average 30 day per share closing market price ("AMP") is less than $4.63 per share; (b) current market price per share if AMP is between $4.63 and $5.09 per share; (c) $5.10 per share if AMP is between $5.10 and $8.93 per share; and (d) $5.56 per share if AMP is higher than $8.93 per share. The Series A Preferred Stock pays dividends at the rate of 6% per annum (paid in kind in additional shares through December 31, 2003, and payable, at the Company's option, in cash beginning in 2004) and will mature and become mandatorily convertible into common stock on September 6, 2005. The holders of Series A Preferred Stock also have the right to participate on an

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as-converted basis in any dividends with respect to the common stock. The holders of Series A Preferred Stock have the right to vote along with the holders of common stock on all matters on which the holders of common stock are entitled to vote, are entitled to vote separately as a class with respect to certain matters, and are also entitled to certain rights of first refusal with respect to future financings. The Series A Preferred Stock is subject to certain customary anti-dilution provisions and has preference over common stock with regard to the distribution of assets upon a liquidation, dissolution or other winding up of the Company.

        On December 31, 2002, a holder of the Series A Preferred Stock elected to convert all 45.9 shares of Series A Preferred Stock that it owned. Based on the AMP in effect on December 31, 2002, the Series A Preferred Stock was converted at $5.10 per share, resulting in the issuance of 900.3 shares of Class A common stock. In addition, the holder's shares of Series B Preferred Stock were redeemed for a nominal cash payment.

        During the years ended December 31, 2001, 2002 and 2003, the Company issued approximately 71, 74 and 77 shares of Series A Preferred Stock, respectively, in connection with payment of the paid-in-kind dividends on such stock. For the years ended December 31, 2001, 2002 and 2003 the Company recorded preferred stock dividends of $7,051, $7,484 and $7,661, respectively. There were no unpaid dividends at December 31, 2003. Preferred stock dividends have been deducted in determining the amount of the net income (loss) available to common stockholders in the consolidated statements of operations.

        In connection with certain waivers and consents by holders of the Series A Preferred Stock relating to the 2002 Offering, the Company authorized 2.0 shares and issued an aggregate of 1.2376 shares of Series B Preferred Stock, $1.00 par value (the "Series B Preferred Stock"), pro rata, to the holders of the Series A Preferred Stock. The Series B Preferred Stock does not pay dividends and has a liquidation preference of no more than $2 in the aggregate. The Company considers the aggregate $1.238 book value of the Series B Preferred Stock to be a cost of raising capital, and consequently recorded that amount as a reduction of additional paid-in capital.

        The certificates of designations governing the Series A Preferred Stock and the Series B Preferred Stock currently give the holders of the Series A Preferred Stock and the Series B Preferred Stock the right to elect four directors if their aggregate ownership of Series A Preferred Stock (on an as-converted basis) equals or exceeds 22.5%, three directors if their aggregate ownership of Series A Preferred Stock equals or exceeds 17.5%, two directors if their aggregate ownership of Series A Preferred Stock equals or exceeds 10%, and one director if their aggregate ownership of Series A Preferred Stock equals or exceeds 5%, respectively, of the sum of the number of outstanding shares of common stock plus the number of shares of common stock into which or for which all outstanding securities convertible into or exercisable or exchangeable for common stock may be converted, exercised or exchanged. A stockholders' agreement dated as of September 6, 2000 between the Company and the holders of the Series A Preferred Stock, as supplemented by a supplemental stockholders' agreement and by a letter agreement between the Company and Mafco, provides SGMS Acquisition Corporation with the right to designate and have appointed four directors if its aggregate ownership of common stock and Series A Preferred Stock (on an as-converted basis) equals or exceeds 20%, three directors if its aggregate ownership of common stock and Series A Preferred Stock equals or exceeds 16%, two directors if its aggregate ownership of common stock and Series A Preferred

87



Stock equals or exceeds 9%, and one director if its aggregate ownership of common stock and Series A Preferred Stock equals or exceeds 4.6%, respectively, of the sum of the number of outstanding shares of common stock plus the number of shares of common stock into which or for which all outstanding securities convertible into or exercisable or exchangeable for common stock may be converted, exercised or exchanged, without including for purposes of the foregoing calculation up to 10 million shares of common stock that may be issued pursuant to, or upon the conversion or exercise of any convertible securities issued pursuant to, the prospectus included in the Company's Registration Statement on Form S-3 (Registration No. 333-110477), which was filed with the SEC on November 13, 2003, amended on February 3, 2004 and declared effective on February 12, 2004. Mafco has consented to the issuance of up to 10 million shares of common stock pursuant to, or upon the conversion or exercise of any convertible securities issued pursuant to, such prospectus. In addition, Mafco has agreed, subject to certain conditions, to waive its right to elect one director under circumstances where the aggregate ownership percentage of the holders would otherwise entitle it to elect four directors. The Company has agreed, during the period in which such waiver is in effect, to recommend to the nominating committee of the Board of Directors, and to use its best efforts to have elected as a director, in addition to Mafco's three remaining designees, Mafco's fourth designee. Mafco's waiver will be effective through and including the Company's 2004 annual meeting.

        In addition, if the Company fails to comply with certain of its obligations, then, as long as such failure continues, the Board of Directors shall be increased by three members, and the holders of Series A Preferred Stock shall have a right to designate and have appointed immediately by the Board of Directors by resolution, or elect, voting as a class, the three new directors.

Common Stock

        The Company has two classes of common stock, consisting of Class A Common Stock and Class B Non-voting Common Stock (the "Class B Common Stock"). All shares of Class A Common Stock and Class B Common Stock entitle holders to the same rights and privileges except that the Class B Common Stock is non-voting. Each share of Class B Common Stock is convertible into one share of Class A Common Stock.

        In July 2002, the Company completed the public offering and sale of 14,375 shares of its Class A Common Stock at a price of $7.25 per share, and used the net proceeds of approximately $98,400 (prior to deducting underwriting discounts, commissions and offering expenses), to redeem approximately $82,957 of its 121/2% Senior Subordinated Notes (see Note 9).

Warrants

        During 2002, the Company issued 1,480 shares of Class A Common Stock upon exercise of certain warrants at a price of $1.69 per share. Some of these warrants were exercised pursuant to an optionable exercise provision that permitted the payment of the exercise price with Class A Common Stock in lieu of a cash payment of the exercise price.

        During 2003, the Company issued 18 shares of Class A Common Stock upon the exercise of 43 warrants at a price of $3.32 per share. These warrants were exercised pursuant to an optionable exercise provision that permitted the payment of the exercise price with Class A Common Stock in lieu

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of a cash payment of the exercise price. The Company also issued 147 shares of Class A Common Stock upon exercise of certain warrants to purchase Class B Common Stock at a price of $3.833 per share. Such Class B Common Shares were converted to Class A Common Shares at the election of the Class B Common Stockholders in accordance with conversion provisions contained in the warrant agreement.

        At December 31, 2003, certain warrants to purchase up to 250 shares of Class A Common Stock were outstanding. Such warrants, which were issued to a financial advisor in connection with its services to the Company in connection with the SGHC acquisition, have an exercise price of $3.58 per share and expire on October 31, 2004.

Employee Stock Purchase Plan

        In 2002, the Company adopted, and its stockholders approved, the Scientific Games Corporation 2002 Employee Stock Purchase Plan (the "ESPP") and reserved 1,000 shares of Class A Common Stock for issuance under the ESPP. The purchase price of the common stock issued pursuant to the exercise of an option under the ESPP will equal 85% of the fair market value of the common stock on (i) the first day of the offering period, or (ii) the last day of the offering period, whichever is less. The number of shares of common stock a participant purchases in each offering period is determined by dividing the total amount of payroll deductions withheld from the participant's compensation during that offering period by the purchase price. The first offering period of the ESPP began in year 2003, and 89 shares of the Company's Class A Common Stock were issued under the ESPP in 2003, at an average price of $6.63 per share.

(13)    Stock Compensation Plans

        The Company has granted stock options and other stock awards under four stock option plans: the 1992 Equity Incentive Plan (the "1992 Plan"); the 1995 Equity Incentive Plan (the "1995 Plan"); the 1997 Incentive Compensation Plan (the "1997 Plan") and the 2003 Incentive Compensation Plan (the "2003 Plan"). On occasion, the Company has also granted stock options outside of these plans.

        In May 1995, the Company offered holders of stock options with exercise prices above market value as of May 26, 1995 the right to cancel such options in exchange for Performance Accelerated Restricted Stock Units ("PARS"). PARS represent deferred shares of Class A Common Stock which vest in 20% increments on the sixth, seventh, eighth, ninth and tenth anniversaries of the date of grant, or, in certain circumstances, on an accelerated basis based on the Company's stock trading at certain per share prices, or at the discretion of the Board of Directors. Options to purchase 1,976 shares were exchanged for 504 PARS. In consideration for the election by certain employees to defer their scheduled vesting of PARS, an additional 4 and 18 PARS were granted for the years ended December 31, 2001 and 2002, respectively.

        Restricted shares and deferred shares with a three-year vesting schedule were granted to certain non-employee directors under the 1992 Plan, the 1997 Plan and the 2003 Plan. A total of 31 restricted shares at a fair market value of $8.75 per share were granted in year 2002 and a total of 37 restricted shares at a fair market value of $7.26 per share were granted in year 2003. In June 2003 the Company granted 48 shares of restricted stock at a fair market value of $7.96 per share under the 2003 plan to

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the Chairman and Chief Executive Officer in connection with an extension of his employment agreement. The restrictions on the shares are scheduled to lapse on the third anniversary of the date of grant. The Company has recorded compensation expenses of $268, $341 and $287 in the years ended December 31, 2001, 2002 and 2003, respectively, as selling, general and administrative expenses in the consolidated statements of operations. Additional compensation expense aggregating $542 will be charged to expense through fiscal 2006 as PARS and restricted shares become fully vested.

        Stock options granted under the Company's equity incentive plans are exercisable at not less than the fair market value of the stock at the date of grant, and none may be exercised more than 10 years from the date of grant. Options are generally exercisable in four equal installments on the first, second, third and fourth anniversaries of the date of grant. The Board of Directors may, in its discretion, accelerate the exercisability, the lapsing of restrictions, or the expiration of deferral or vesting period of any award under the plans.

        Information with respect to the Company's stock options is as follows:

Stock Options

  Shares
  Average
Price (1)

Outstanding at December 31, 2000   8,395   $ 2.80
   
     
  Granted   2,015     4.73
  Canceled   305     3.99
  Exercised   578     1.86
   
     
Outstanding at December 31, 2001   9,527     3.24
   
     
  Granted   1,732     6.75
  Canceled   250     3.83
  Exercised   1,782     2.90
   
     
Outstanding at December 31, 2002   9,227     3.95
   
     
  Granted   2,533     11.14
  Canceled   452     7.47
  Exercised   1,973     2.41
   
     
Outstanding at December 31, 2003   9,335     6.06
   
     

(1)
Weighted average exercise price

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        Summarized information about stock options outstanding and exercisable at December 31, 2003 is as follows:

 
  Outstanding
  Exercisable
Exercisable Price Range

  Shares
  Average
Life (1)

  Average
Price (2)

  Shares
  Average
Price (2)

$1.00 to 2.00   721   3.9   $ 1.38   721   $ 1.38
$2.01 to 3.00   2,635   4.9     2.77   2,040     2.76
$3.01 to 4.00   1,034   6.3     3.50   747     3.49
$4.01 to 7.00   2,097   7.2     5.91   956     5.47
  over $7.00   2,848   8.7     11.35   832     7.85
   
           
     
    9,335   6.7     6.06   5,296     3.96
   
           
     

(1)
Weighted average contractual life remaining in years.

(2)
Weighted average exercise price.

        The number of shares and weighted average exercise price per share of options exercisable at December 31, 2001, 2002 and 2003 were 5,398 shares at $2.81, 4,912 shares at $2.96 and 5,296 shares at $3.96, respectively. At December 31, 2001, 2002 and 2003, 2,223 shares, 670 shares and 5,043 shares, respectively, were available for future grants under the terms of the Company's stock option plans. Outstanding options expire prior to December 8, 2013 and are exercisable at prices ranging from $1.0625 to $17.00 per share.

(14)    Service Contract Arrangements

        Service contracts for North American pari-mutuel wagering systems and lottery systems generally provide for substantial related services such as software, maintenance personnel, computer operators and certain operating supplies. The service contracts generally cover five to seven year periods and frequently include renewal options that have generally been exercised by the customers. Under such contracts, the Company retains ownership of all equipment. The service contracts also provide for certain warranties covering operation of the equipment, machines, display equipment and central computing equipment. The breach of such warranties could result in significant liquidated damages. The service contracts provide for revenue based on a percentage of total amounts wagered. Certain pari-mutuel wagering systems contracts provide for specified minimum levels of revenue. The Company has historically exceeded such minimums.

        Instant ticket sales contracts provide for revenue based on a fixed fee per thousand instant tickets or a percentage of instant ticket retail sales of the lottery customer. Instant ticket contracts generally run for one to five years and frequently include renewal options.

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(15)    Export Sales and Major Customers

        Sales to foreign customers amounted to $45,891, $28,580 and $28,555 in the years ended December 31, 2001, 2002 and 2003, respectively. No single customer represented more than 10% of revenues during the year ended December 31, 2003.

(16)    Pension Plans

        The Company has two funded defined benefit pension plans. It has a defined benefit plan for its U.S. based union employees. Retirement benefits under this plan are based upon the number of years of credited service up to a maximum of 30 years for the majority of the employees. It also has a defined benefit plan for U.K. based employees. Retirement benefits under the U.K. plan are based on an employee's average compensation over the two years preceding retirement. The Company's policy is to fund the minimum contribution permissible by the respective tax authorities. The Company estimates that the amount to be funded in year 2004 will approximate $2,200.

        The Company also has an unfunded, nonqualified Supplemental Executive Retirement Plan (the "SERP"), which is intended to provide supplemental retirement benefits for certain senior executives of the Company. The SERP provides for retirement benefits according to a formula based on each participant's compensation and years of service with the Company. The projected benefit obligation and accumulated benefit obligation for this plan were $7,384 and $5,919 at December 31, 2002 and $11,012 and $9,046 at December 31, 2003.

        The Company consults with its independent actuaries when selecting the discount rate assumptions used to determine benefit obligations and net periodic cost. In selecting the discount rate for the U.S. Plan and the SERP Plan, the Company considers fixed-income security yields, specifically AA-rated corporate bonds, as rated by Moody's Investor Service. The discount rate assumptions for the benefit obligations for the plans were as follows: U.S. Plan—6.5% for 2002 and 6.0% for 2003; SERP—6.75% for 2002 and 6.25% for 2003; and U.K. Plan—5.75% for 2002 and 5.5% for 2003. The discount rate assumptions for the net periodic cost of the plans were as follows: U.S. Plan—7% for 2002 and 6.5% for 2003; SERP—7.5% for 2002 and 6.75% for 2003; and U.K. Plan—5.75% for 2002 and 5.5% for 2003.

        The plan assets for the U.S. based plan are invested in Cigna General Account Fund (the "Fund"), which is guaranteed as to principal. In estimating the expected return on the U.S. Plan assets, the Company considers past performance and future expectations for the Fund. At December 31, 2003, the Company made no change from the prior year in the expected 6.5% return on its U.S. Plan assets, as historical returns continue to support the expected return. The SERP Plan has not been funded. The plan assets for the U.K. based plan are primarily invested in equity securities, and the expected return on plan assets was 8% for 2002 and 2003.

        The calculation of benefits under the U.K. Plan reflects compensation increases of 2.5% in 2002 and 3.0% in 2003. The calculation of benefits under the SERP reflects compensation increases of 4.0% in 2002 and 2003.

        The Company uses a measurement date of December 31 for its pension plans.

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        The following table sets forth the combined funded status of the plans and their reconciliation with the related amounts recognized in our consolidated financial statements at the December 31 measurement dates:

 
  December 31,
 
 
  2002
  2003
 
Change in benefit obligation            

Benefit obligation at beginning of year

 

$

21,668

 

31,886

 
Service cost     1,523   2,275  
Interest cost     1,536   2,048  
Participant contributions     805   854  
Amendments     878   1,759  
Actuarial loss     4,378   6,835  
Benefits paid     (302 ) (574 )
Other, principally foreign exchange     1,400   2,108  
   
 
 
Benefit obligation at end of year   $ 31,886   47,191  
   
 
 

Change in plan assets

 

 

 

 

 

 
Fair value of plan assets at
beginning of year
  $ 14,965   16,202  
Actual gain (loss) on plan assets     (2,482 ) 3,166  
Employer contributions     1,930   2,087  
Plan participant contributions     805   854  
Benefits paid     (302 ) (574 )
Other, principally foreign exchange     1,286   1,294  
   
 
 
Fair value of assets at end of year   $ 16,202   23,029  
   
 
 

Funded status

 

$

(15,684

)

(24,162

)
Unrecognized actuarial loss     10,624   15,986  
Unrecognized prior service cost     4,425   5,627  
Unrecognized net transition obligation     17   12  
   
 
 
Net liability amount recognized   $ (618 ) (2,537 )
   
 
 

Amounts recognized in the Consolidated Balance Sheets:

 

 

 

 

 

 
Accrued benefit liability   $ (9,938 ) (14,219 )
Intangible asset     3,484   4,933  
Accumulated other comprehensive income     3,758   4,896  
Prepaid pension cost     2,078   1,853  
   
 
 
Net amount recognized   $ (618 ) (2,537 )
   
 
 

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  December 31,
 
 
  2001
  2002
  2003
 
Components of net periodic pension benefit cost:                
Service cost   $ 1,608   1,523   2,275  
Interest cost     1,391   1,536   2,048  
Expected return on plan assets     (1,205 ) (1,465 ) (1,481 )
Actuarial loss       129   738  
Net amortization and deferral     196   45   54  
Amortization of prior service costs     457   454   532  
   
 
 
 
Net periodic cost   $ 2,447   2,222   4,166  
   
 
 
 

        The accumulated benefit obligation for all defined benefit pension plans was $26,139 and $37,738 at December 31, 2002 and 2003, respectively. As required by Financial Accounting Standards Board Statement No. 87, Employers' Accounting for Pensions ("SFAS 87"), for pension plans for which the accumulated benefit obligation exceeds the fair value of plan assets, the Company has recognized in the consolidated balance sheet at December 31, 2002 and 2003 the additional minimum liability of the unfunded accumulated benefit obligation of $7,243 and $9,829, respectively, as a long-term liability, with a partially offsetting intangible asset and equity adjustment.

        In connection with its U.S. based collective bargaining agreements, the Company participates with other companies in a defined benefit pension plan covering union employees. Payments made to the multi-employer plan were approximately $259, $244 and $240 during the years ended December 31, 2001, 2002 and 2003, respectively.

        The Company has a 401(k) plan covering all U.S. based employees who are not covered by a collective bargaining agreement. Company contributions to the plan are at the discretion of the Company's Board of Directors. Pension expense for the years ended December 31, 2001, 2002 and 2003 amounted to approximately $1,624, $1,537 and $3,456, respectively. The Company has a 401(k) plan for all union employees which does not provide for Company contributions.

        The SERP is not a qualified plan. In 2003, to provide a source for the payment of certain benefits under the SERP, the Company made an initial $14,700 cash payment to a rabbi trust, which in turn made a $4,900 payment for whole-life insurance policies on the participants. These policies have been placed in the rabbi trust, which will hold the policies and death benefits as they are received. The cash value of these policies was approximately $5,095 at December 31, 2003.

94


(17)    Income Tax Expense

        The consolidated income (loss) before income tax expense, by domestic and foreign source, is as follows:

 
  Years Ended December 31,
 
 
  2001
  2002
  2003
 
Domestic   $ (12,350 ) (1,446 ) 61,550  
Foreign     13,555   14,303   19,916  
   
 
 
 
Consolidated income before income tax expense   $ 1,205   12,857   81,466  
   
 
 
 

Income tax expense (benefit) consists of:

 

 

 

 

 

 

 

 

 

 

Current


 

Deferred


 

Total


 
Year Ended December 31, 2001                
  Federal   $ (499 ) 2,272   1,773  
  Foreign     3,496   498   3,994  
  State     672   (372 ) 300  
   
 
 
 
  Total   $ 3,669   2,398   6,067  
   
 
 
 

Year Ended December 31, 2002

 

 

 

 

 

 

 

 
  Federal   $   (29,909 ) (29,909 )
  Foreign     5,069   (427 ) 4,642  
  State     775   (2,383 ) (1,608 )
   
 
 
 
  Total   $ 5,844   (32,719 ) (26,875 )
   
 
 
 

Year Ended December 31, 2003

 

 

 

 

 

 

 

 
  Federal   $ 8,045   12,217   20,262  
  Foreign     4,435   616   5,051  
  State     2,177   1,829   4,006  
   
 
 
 
  Total   $ 14,657   14,662   29,319  
   
 
 
 

95


        Temporary differences between the financial statement carrying amounts and tax basis of assets and liabilities that give rise to significant portions of the deferred tax asset (liabilities) relate to the following:

 
  December 31,
 
 
  2002
  2003
 
Deferred Tax Assets            
  Inventory   $ 2,726   2,369  
  Reserve for doubtful accounts     715   952  
  Accrued litigation expenses     828   422  
  Accrued vacation     754   754  
  Other accrued liabilities     825   14,277  
  Deferred compensation     1,702   3,052  
  Partnership investments     273   273  
  Accumulated other comprehensive income items     1,323   566  
  Net operating loss carryforward     60,701   50,716  
  Foreign tax credits     1,600   2,188  
  Alternative minimum tax credits     221   221  
  Research and experimentation credits     32   32  
  Valuation allowance     (8,992 ) (8,992 )
   
 
 
    Total deferred tax assets     62,708   66,830  
   
 
 
Deferred Tax Liabilities            
  Prepaid expense     (300 ) (152 )
  Deferred costs     (3,155 ) (2,588 )
  Intangible assets-difference in basis and amortization periods     (22,806 ) (22,443 )
  Property and equipment-differences in basis and depreciation methods     (10,926 ) (8,936 )
  Interest charge, Domestic International Sales Corp.     (6,493 ) (7,064 )
   
 
 
    Total deferred tax liabilities     (43,680 ) (41,183 )
   
 
 
    Net deferred tax assets on balance sheet   $ 19,028   25,647  
   
 
 
Amounts recognized in the Consolidated Balance Sheet consist of:            
  Current deferred tax assets   $ 11,093   15,833  
  Non-current deferred tax assets     12,109   14,409  
  Non-current deferred tax liabilities     (4,174 ) (4,595 )
   
 
 
  Net deferred tax assets on balance sheet   $ 19,028   25,647  
   
 
 

        Certain reclassifications have been made to prior year amounts to conform to current presentation.

96


        The aggregate deferred tax assets before valuation allowance at December 31, 2002 and 2003 were $71,700 and $75,822, respectively. The aggregate deferred tax liabilities at December 31, 2002 and 2003 were $43,680 and $41,183, respectively.

        The actual tax expense differs from the "expected" tax expense (computed by applying the U.S. federal corporate rate to income before income tax expense) as follows:

 
  Years Ended
December 31,

 
 
  2001
  2002
  2003
 
Statutory U.S. federal income tax rate     34 % 35 % 35 %
Computed "expected" tax expense   $ 410   4,500   28,513  
Increase (reduction) in income taxes resulting from:                
  Change in valuation allowance     3,961   (31,582 )  
  State income tax expense     300   1,381   2,604  
  Foreign tax differential     (615 ) (1,928 ) (2,903 )
  Non deductible goodwill amortization and other     2,272      
  Other, net     (261 ) 754   1,105  
   
 
 
 
    $ 6,067   (26,875 ) 29,319  
   
 
 
 

        The Company has regular tax net operating loss carryforwards of approximately $154 that expire in 2009, $39,849 that expire in 2010, $25,406 that expire in 2011, $9,151 that expire in 2012, $12 that expire in 2016, $2,108 that expire in 2017, $10,691 that expire in 2018, $6 that expire in 2019, $37,097 that expire in 2020 and $3,017 that expire in 2022. In connection with the fiscal 2000 acquisition of SGHC and the concurrent sale of Series A Convertible Preferred Stock, the Company incurred an ownership change pursuant to Section 382 of the Internal Revenue Code of 1986. As a result, the availability of tax net operating loss carryforwards realized by the Company prior to the change in ownership, totaling approximately $120,000, to offset post acquisition taxable income is limited to approximately $7,500 annually, except with respect to taxable income, if any, attributable to sales of pre-acquisition assets.

        The Company has minimum tax credit carryforwards (which can be carried forward indefinitely) of approximately $221 and research and experimentation credit carryforwards of approximately $32. The research and experimentation credits expire in 2020.

        The net change in the valuation allowance for deferred tax assets for the years ended December 31, 2001 and 2002 was an increase of $24,863 and a decrease of $31,582, respectively. There was no change in the valuation allowance for deferred tax assets for the year ended December 31, 2003.

        Subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets as of December 31, 2003 will be allocated as follows:

Income tax benefit that would be reported in the consolidated statements of operations   $ 4,008
Additional capital (benefit from exercise of stock options)     4,984
   
    $ 8,992
   

97


        U.S. income taxes have not been provided on undistributed earnings of international subsidiaries. The Company's intention is to reinvest these earnings permanently or to repatriate the earnings only when it is tax effective to do so. Accordingly, the Company believes that any U.S. tax on repatriated earnings would be substantially offset by U.S. foreign tax credits.

(18)    Business and Geographic Segments

        Business segments are defined by Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information ("SFAS 131"), as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker assessing performance and making operating and capital decisions.

        The following tables represent revenues, profits, depreciation and amortization and assets by business and geographic segments for the years ended December 31, 2001, 2002 and 2003. Operating revenues are allocated among geographic segments based on where the customer is located. Gross profit excludes depreciation and amortization. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in Note 1. Corporate expenses, including depreciation and amortization, interest expenses and other income or expenses are not allocated among business and geographic segments.

 
  Year Ended December 31, 2001
 
  Lottery
Group

  Pari-Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products Group

  Totals
Service revenues   $ 223,875   79,779   60,913       364,567
Sales revenues     13,936   19,554     42,184     75,674
   
 
 
 
 
Total revenues     237,811   99,333   60,913   42,184     440,241
   
 
 
 
 
Cost of service     141,442   46,663   43,180       231,285
Cost of sales     9,602   11,817     25,739     47,158
Amortization of service contract software     1,705   2,661         4,366
   
 
 
 
 
Total operating expenses     152,749   61,141   43,180   25,739     282,809
   
 
 
 
 
Gross profit     85,062   38,192   17,733   16,445     157,432
Selling, general and administrative expenses     25,635   10,738   2,625   4,935     43,933
Depreciation and amortization     32,217   12,131   2,674   1,804     48,826
   
 
 
 
 
Segment operating income   $ 27,210   15,323   12,434   9,706     64,673
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       13,068
                     
Consolidated operating income                     $ 51,605
                     
Assets at December 31, 2001   $ 289,971   226,650   32,977   36,198     585,796
   
 
 
 
 
Capital and wagering systems expenditures   $ 39,756   3,721   1,169   1,847     46,493
   
 
 
 
 

98


 
  Year Ended December 31, 2002
 
  Lottery Group
  Pari-Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products Group

  Totals
Service revenues   $ 239,219   81,546   62,053       382,818
Sales revenues     20,721   5,692     46,022     72,435
   
 
 
 
 
Total revenues     259,940   87,238   62,053   46,022     455,253
   
 
 
 
 
Cost of service     131,602   46,677   42,759       221,038
Cost of sales     14,474   2,751     30,187     47,412
Amortization of service contract software     2,328   2,602         4,930
   
 
 
 
 
Total operating expenses     148,404   52,030   42,759   30,187     273,380
   
 
 
 
 
Gross profit     111,536   35,208   19,294   15,835     181,873
Selling, general and administrative expenses     26,900   10,675   2,821   4,520     44,916
Depreciation and amortization     21,646   11,679   1,789   2,241     37,355
   
 
 
 
 
Segment operating income   $ 62,990   12,854   14,684   9,074     99,602
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       18,766
                     
Consolidated operating income                     $ 80,836
                     
Assets at December 31, 2002   $ 293,385   258,435   38,634   46,335     636,789
   
 
 
 
 
Capital and wagering systems expenditures   $ 19,065   8,344   2,153   1,455     31,017
   
 
 
 
 

99


 
  Year Ended December 31, 2003
 
  Lottery
Group

  Pari-
Mutuel
Group

  Venue
Management
Group

  Telecom-
munications
Products
Group

  Totals
Service revenues   $ 307,820   80,798   63,946       452,564
Sales revenues     54,685   5,399     48,263     108,347
   
 
 
 
 
Total revenues     362,505   86,197   63,946   48,263     560,911
   
 
 
 
 
Cost of service     159,447   43,476   44,807       247,730
Cost of sales     40,884   2,790     32,408     76,082
Amortization of service contract software     2,947   2,365         5,312
   
 
 
 
 
Total operating expense     203,278   48,631   44,807   32,408     329,124
   
 
 
 
 
Gross profit     159,227   37,566   19,139   15,855     231,787
Selling, general and administrative expenses     40,538   11,208   3,403   4,998     60,147
Depreciation and amortization     25,319   11,718   2,001   2,630     41,668
   
 
 
 
 
Segment operating income   $ 93,370   14,640   13,735   8,227     129,972
   
 
 
 
     
Unallocated corporate selling, general and administrative costs, and depreciation and amortization                       20,632
                     
Consolidated operating income                     $ 109,340
                     
Assets at December 31, 2003   $ 566,790   317,569   35,283   43,347     962,989
   
 
 
 
 
Capital and wagering systems expenditures   $ 26,663   6,639   830   1,476     35,608
   
 
 
 
 

100


        The following table provides a reconciliation of segment operating income to the consolidated income before income tax expense for each period:

 
  Years Ended December 31,
 
 
  2001
  2002
  2003
 
Reportable segment operating income   $ 64,673   99,602   129,972  
Unallocated corporate expense     (13,068 ) (18,766 ) (20,632 )
Interest expense     (50,363 ) (44,842 ) (26,397 )
Other expense     (37 ) (636 ) (1,184 )
Early extinguishment of debt       (22,501 ) (293 )
   
 
 
 

Income before income tax expense

 

$

1,205

 

12,857

 

81,466

 
   
 
 
 
 
  Years Ended December 31,
 

 

 

2001


 

2002


 

2003


 
Geographic Segments                
Service and Sales Revenue:                
  North America   $ 298,612   323,246   416,372  
  Europe, other than United Kingdom     107,401   88,340   98,429  
  United Kingdom     6,691   9,788   10,383  
  Other     27,537   33,879   35,727  
   
 
 
 
    $ 440,241   455,253   560,911  
   
 
 
 
Long-lived assets (excluding identifiable intangibles):                
  North America   $ 160,952   156,746   176,186  
  Europe, other than United Kingdom     6,720   7,947   7,619  
  United Kingdom     26,988   30,872   32,653  
  Other     2,128   5,301   12,272  
   
 
 
 
    $ 196,788   200,866   228,730  
   
 
 
 

101


(19)    Selected Quarterly Financial Data (Unaudited)

 
  Quarter Ended
March 31, 2002

  Quarter Ended
June 30, 2002

  Quarter Ended
September 30, 2002(1)

  Quarter Ended
December 31, 2002(1)

Total operating revenues   $ 106,972   114,267   115,152   118,862
Operating expenses     62,487   66,913   69,079   69,971
Amortization of service contract software     1,209   1,214   1,233   1,274
   
 
 
 
Gross profit     43,276   46,140   44,840   47,617
Net income (loss)     (3,009 ) 8,122   (5,787 ) 40,406
Convertible preferred stock paid-in-kind dividend     1,803   1,851   1,899   1,931
   
 
 
 
Net income (loss) available to common stockholders   $ (4,812 ) 6,271   (7,686 ) 38,475
   
 
 
 

Basic and diluted earnings (loss) per share:

 

 

 

 

 

 

 

 

 
Basic net income (loss) available to common stockholders   $ (0.11 ) 0.15   (0.13 ) 0.66
   
 
 
 
Diluted net income (loss) available to common stockholders   $ (0.11 ) 0.11   (0.13 ) 0.46
   
 
 
 

Weighted average number of shares used in per share calculations:

 

 

 

 

 

 

 

 

 
Basic shares     42,067   43,048   57,301   58,243
   
 
 
 
Diluted shares     42,067   71,983   57,301   88,033
   
 
 
 

(1)
Reclassifications to Prior Years' Consolidated Financial Statements: Effective January 1, 2003, we adopted FASB Statement No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds Statement No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect, and requires the criteria in Accounting Principles Board Opinion No. 30 to be used to classify gains and losses. Accordingly, in 2002, the Company reclassified $22,501 extraordinary losses incurred in 2002 to other deductions—early extinguishment of debt. Of this amount, $15,590 occurred in the quarter ended September 30, 2002 and $6,911 occurred in the quarter ended December 31, 2002.

102


 
  Quarter Ended
March 31, 2003

  Quarter Ended
June 30, 2003

  Quarter Ended
September 30, 2003

  Quarter Ended
December 31, 2003

Total operating revenues   $ 123,218   128,849   132,063   176,781
Operating expenses     70,035   72,417   75,403   105,957
Amortization of service contract software     1,267   1,344   1,325   1,376
   
 
 
 
Gross profit     51,916   55,088   55,335   69,448
Net income     11,321   12,570   13,237   15,019
Convertible preferred stock paid-in-kind dividend     1,847   1,895   1,942   1,977
   
 
 
 
Net income available to common stockholders   $ 9,474   10,675   11,295   13,042
   
 
 
 

Basic and diluted earnings per share:

 

 

 

 

 

 

 

 

 
Basic net income available to common stockholders   $ 0.16   0.18   0.19   0.21
   
 
 
 
Diluted net income available to common stockholders   $ 0.13   0.14   0.15   0.17
   
 
 
 

Weighted average number of shares used in per share calculations:

 

 

 

 

 

 

 

 

 
Basic shares     59,450   59,868   60,123   60,756
   
 
 
 
Diluted shares     87,932   89,228   89,196   90,914
   
 
 
 

103


(20)    Accumulated Other Comprehensive Income

        The accumulated balances for each classification of comprehensive income are as follows:

 
  Foreign
Currency
Items

  Unrealized
Gains (Losses)
On Securities

  Minimum
Pension
Liability

  Cash Flow
Hedges

  Accumulated
Other
Comprehensive
Income

 
Balance at December 31, 2000   $ (1,315 ) (957 ) (607 ) (2,395 ) (5,274 )
Change during period     (296 ) 2   38   (7,816 ) (8,072 )
Reclassification adjustments for losses reclassified into operations           2,962   2,962  
   
 
 
 
 
 
Balance at December 31, 2001   $ (1,611 ) (955 ) (569 ) (7,249 ) (10,384 )
Change during period (1)     4,758   100   (2,261 ) (1,193 ) 1,404  
Reclassification adjustments for losses reclassified into operations           8,654   8,654  
   
 
 
 
 
 
Balance at December 31, 2002   $ 3,147   (855 ) (2,830 ) 212   (326 )
Change during period (1)     7,181   891   (781 ) (7,633 ) (342 )
Reclassification adjustments for losses reclassified into operations           6,314   6,314  
   
 
 
 
 
 
Balance at December 31, 2003   $ 10,328   36   (3,611 ) (1,107 ) 5,646  
   
 
 
 
 
 

(1)
Amounts originating in years 2002 and 2003 are net of income taxes. No adjustments were made for income tax benefits in year 2001 as the Company had only recognized tax benefits of prior period operating losses to the extent such losses would be offset by net taxable temporary differences expected to reverse during the carryforward period.

(21)    Unusual Items

        In 2003, administrative expenses included $3,010 of costs associated with the move of the Company's pari-mutuel racing operations from Delaware to Georgia.

        In 2002, the Company recognized unusual charges in the amount of $1,055 primarily due to investigation and other costs attributable to the Pick Six matter (see Note 22). In addition, interest expense in 2002 included approximately $3,276 of debt restructuring charges relating to the refinancing of the 2000 Facility in December 2002. These charges resulted from the early termination of three interest rate swap agreements that were required to be maintained pursuant to the terms of the 2000 Facility. (See Note 9.)

        In 2001, the Company reversed reserves of $1,500 in connection with a litigation that was settled.

104


(22)    Litigation

        Although the Company is a party to various claims and legal actions arising in the ordinary course of business, the Company believes, on the basis of information presently available to it, that the ultimate disposition of these matters will not likely have a material adverse effect on its consolidated financial position or results of operations.

        The Company's subsidiary Scientific Games International, Inc. ("SGI") owned a minority interest in Wintech de Colombia S.A., or Wintech (now liquidated), which formerly operated the Colombian national lottery under contract with Empresa Colombiana de Recursos para la Salud, S.A. ("Ecosalud"), an agency of the Colombian government. The contract projected that certain levels of lottery ticket sales would be attained and provided a penalty against Wintech, SGI and the other shareholders of Wintech of up to $5,000 if such performance levels were not achieved. In addition, with respect to a further guarantee of performance under the contract with Ecosalud, SGI delivered to Ecosalud a $4,000 bond issued by a Colombian surety, Seguros del Estado ("Seguros"). Wintech started the instant lottery in Colombia, but, due to difficulties beyond its control, including, among other factors, social and political unrest in Colombia, frequently interrupted telephone service and power outages, and competition from another lottery being operated in a province of Colombia which the Company believes was in violation of Wintech's exclusive license from Ecosalud, the projected sales level was not met for the year ended June 30, 1993. On July 1, 1993, Ecosalud adopted resolutions declaring, among other things, that the contract was in default and asserted various claims for compensation and penalties against Wintech, SGI and other shareholders of Wintech. Litigation is pending and/or threatened in Colombia concerning various claims among Ecosalud, Wintech and SGI, relating to the termination of the contracts with Ecosalud. Ecosalud's claims are for, among other things, realization of the full amount of the penalty, plus interest and costs of the bond. In 2002 the Colombian Government enacted new gaming and lottery legislation which included the dissolution of Ecosalud. A new company, Empresa Territorial para la Salud ("Etesa") was incorporated replacing Ecosalud. Etesa is the legal successor to Ecosalud with respect to the pending litigation.

        The Colombian surety, Seguros, paid $2,400 to Ecosalud under its $4,000 bond, and made demand upon SGI for that amount under the indemnity agreement between the surety and SGI. SGI declined to make or authorize any such payment and notified the surety that any payment in response to Ecosalud's demand on the bond was at the surety's risk. In a case brought in U.S. District Court in Georgia, the Colombian surety sought to recover from SGI sums paid (in SGI's view, improperly) under its surety bond, plus interest. In September 1999, the District Court granted summary judgment for the surety in the amount of approximately $7,000 (which included pre-judgment interest at a rate of 38.76% per annum). On appeal, the United States Court of Appeals for the Eleventh Circuit, on August 20, 2001, affirmed the judgment for the principal amount of $2,400, but vacated that part of the judgment awarding approximately $4,600 based on a pre-judgment interest rate of 38.76% with instructions to the District Court to recalculate pre-judgment interest. On February 22, 2002, SGI agreed to settle this matter upon payment of $3,700 to the Colombian surety. On February 26, 2002, SGI drew upon a $1,500 letter of credit posted by a former Colombian partner in order to partially fund this payment. This settlement resolves the U.S. litigation with the surety, but the claims in Colombia remain unresolved.

        In July 2002, the Tribunal Contencioso of Cundinamarca denied SGI's preliminary motion to dismiss Etesa's pending lawsuit against SGI seeking the collection of amounts that Etesa claims are

105



owed by SGI. By decision dated August 2003, of which SGI received notice in January 2004, such denial was upheld by the Council of State, the highest appellate court with jurisdiction over this matter. As a result of these decisions, this lawsuit, which is in its early stages, will be heard in due course on its merits by the Tribunal Contencioso of Cundinamarca.

        SGI has various defenses on the merits as well as procedural defenses that it plans to assert against Ecosalud's claims. The Company intends to vigorously pursue these defenses as appropriate. SGI also has certain cross indemnities and undertakings from the two other privately held shareholders of Wintech for their respective shares of any liability to Ecosalud. No assurance can be given that the other shareholders of Wintech will, or have sufficient assets to, honor their indemnity undertakings to SGI when the claims by Ecosalud against SGI and Wintech are finally resolved, in the event such claims result in any final liability. Although the Company believes that any potential losses arising from these claims will not result in a material adverse effect on its consolidated financial position or results of operations, it is not feasible to predict the final outcome, and there can be no assurance that these claims might not be finally resolved adversely to the Company or result in material liability.

        On December 4, 2002, a class action lawsuit (Allard v. Autotote / Scientific Games Corporation, and Does 1-10 (L. A. Superior Court No. BC 286382)) was filed against the Company in state court in California by a professional Pick Six bettor on behalf of pari-mutuel bettors in the U.S., alleging, among other things, negligence, breach of contract and deceptive trade practices arising from the Company's handling of multiple-race wagers. The Company removed the case to federal court, and moved to dismiss the lawsuit. On June 2, 2003, the federal court judge dismissed the action finding that plaintiff's claims were barred as a matter of law and public policy. Subsequently, on July 8, 2003, the federal court judge determined that he did not have subject matter jurisdiction over the case and set aside his previous dismissal order and remanded the case to state court. The Company has moved to dismiss plaintiff's second amended complaint without leave to amend.

        Subsequent to the end of our 2003 fiscal year, on March 4, 2004, a lawsuit (GTech Corporation v. Scientific Games International, Inc., Scientific Games Holdings Corporation, Scientific Games Finance Corporation and Scientific Games Corporation (U.S. District Court for the District of Delaware, Civil Action No. 04-0138)) was filed against the Company in federal court in Delaware. The lawsuit alleges that the Company has infringed upon two patents owned by GTech Corporation concerning instant lottery ticket vending and dispensing machines and methods. The Company believes that the lawsuit lacks merit, and the Company intends to contest the suit vigorously.

(23)    Financial Information for Guarantor Subsidiaries and Non-Guarantor Subsidiaries

        The Company conducts substantially all of its business through its domestic and foreign subsidiaries. The Notes and the 2003 Facility entered into on November 6, 2003 to refinance all obligations under the then existing 2002 Facility are fully, unconditionally and jointly and severally guaranteed by substantially all of the Company's wholly-owned domestic subsidiaries (the "Guarantor Subsidiaries").

        Presented below is condensed consolidating financial information for (i) Scientific Games Corporation (the "Parent Company"), which includes the activities of Scientific Games Management Corporation, (ii) the Guarantor Subsidiaries and (iii) the wholly-owned foreign subsidiaries and the

106



non-wholly owned domestic and foreign subsidiaries (the "Non-Guarantor Subsidiaries") as of December 31, 2002 and December 31, 2003 and for the years ended December 31, 2001, 2002 and 2003. The condensed consolidating financial information has been presented to show the nature of assets held, results of operations and cash flows of the Parent Company, the Guarantor Subsidiaries and the Non-Guarantor Subsidiaries assuming the guarantee structure of the 2003 Facility and the Notes were in effect at the beginning of the periods presented. Separate financial statements for the Guarantor Subsidiaries are not presented based on management's determination that they would not provide additional information that is material to investors.

        The condensed consolidating financial information reflects the investments of the Parent Company in the Guarantor and Non-Guarantor Subsidiaries using the equity method of accounting. In addition, corporate interest and administrative expenses have not been allocated to the subsidiaries.


SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2002

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
ASSETS                      
  Cash and cash equivalents   $ 25,323   180   9,426     34,929
  Accounts receivable, net       35,521   17,779   (40 ) 53,260
  Inventories       16,591   4,480   (536 ) 20,535
  Other current assets     10,810   6,988   4,826   30   22,654
  Property and equipment, net     3,572   151,366   46,559   (631 ) 200,866
  Investment in subsidiaries     348,585   4,240     (352,825 )
  Goodwill     183   179,672   3,915     183,770
  Intangible assets       52,892   4,930     57,822
  Other assets     26,784   38,693   6,001   (8,525 ) 62,953
   
 
 
 
 
    Total assets   $ 415,257   486,143   97,916   (362,527 ) 636,789
   
 
 
 
 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

 

 

 

 

 
 
Current installments of long-term debt

 

$

3,281

 

9

 

575

 


 

3,865
  Current liabilities     13,342   49,047   17,970   639   80,998
  Long-term debt, excluding current installments     356,418   1   245     356,664
  Other non-current liabilities     (13,464 ) 28,972   10,845   139   26,492
  Intercompany balances     (113,090 ) 96,751   17,822   (1,483 )
  Stockholders' equity     168,770   311,363   50,459   (361,822 ) 168,770
   
 
 
 
 
Total liabilities and stockholders' equity   $ 415,257   486,143   97,916   (362,527 ) 636,789
   
 
 
 
 

107



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2003

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
ASSETS                
  Cash and cash equivalents   $ 67,618   (4,473 ) 16,228     79,373
  Accounts receivable, net       77,670   22,008   (39 ) 99,639
  Inventories       19,716   7,788   (608 ) 26,896
  Other current assets     4,686   17,005   9,736   30   31,457
  Property and equipment, net     3,135   171,692   54,534   (631 ) 228,730
  Investment in subsidiaries     469,385   184,313     (653,698 )
  Goodwill     183   304,117   4,055     308,355
  Intangible assets       86,982   4,466     91,448
  Other assets     47,159   49,293   8,940   (8,301 ) 97,091
   
 
 
 
 
    Total assets   $ 592,166   906,315   127,755   (663,247 ) 962,989
   
 
 
 
 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

 

 
 
Current installments of long-term debt

 

$

5,015

 

654

 

658

 


 

6,327
  Current liabilities     15,615   110,158   25,370   953   152,096
  Long-term debt, excluding current installments     525,664     172     525,836
  Other non-current liabilities     (3,844 ) 31,633   13,689   100   41,578
  Intercompany balances     (203,592 ) 189,865   15,524   (1,797 )
  Stockholders' equity     253,308   574,005   72,342   (662,503 ) 237,152
   
 
 
 
 
    Total liabilities and stockholders' equity   $ 592,166   906,315   127,755   (663,247 ) 962,989
   
 
 
 
 

108



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2001

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
 
Operating revenues   $   338,626   115,434   (13,819 ) 440,241  
Operating expenses       211,193   80,728   (13,478 ) 278,443  
Amortization of service contract software       4,366       4,366  
   
 
 
 
 
 
  Gross profit       123,067   34,706   (341 ) 157,432  

Selling, general and administrative expenses

 

 

12,762

 

32,310

 

11,664

 

(41

)

56,695

 
Depreciation and amortization     306   40,867   8,032   (73 ) 49,132  
   
 
 
 
 
 
Operating income (loss)     (13,068 ) 49,890   15,010   (227 ) 51,605  
Interest expense     49,880   410   2,009   (1,936 ) 50,363  
Other (income) deductions     (596 ) (2,545 ) 1,148   2,030   37  
   
 
 
 
 
 
Income (loss) before equity in income of subsidiaries, and income taxes     (62,352 ) 52,025   11,853   (321 ) 1,205  
Equity in income of subsidiaries     63,532       (63,532 )  
Income tax expense (benefit)     6,042   (3,122 ) 3,147     6,067  
   
 
 
 
 
 

Net income (loss)

 

$

(4,862

)

55,147

 

8,706

 

(63,853

)

(4,862

)
   
 
 
 
 
 

109



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2002

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
 
Operating revenues   $   347,702   118,762   (11,211 ) 455,253  
Operating expenses       199,209   80,265   (11,024 ) 268,450  
Amortization of service contract software       4,530   400     4,930  
   
 
 
 
 
 
  Gross profit       143,963   38,097   (187 ) 181,873  

Selling, general and administrative expenses

 

 

19,271

 

32,590

 

11,283

 

(12

)

63,132

 
Depreciation and amortization     550   29,229   8,134   (8 ) 37,905  
   
 
 
 
 
 
  Operating income (loss)     (19,821 ) 82,144   18,680   (167 ) 80,836  
Interest expense     44,112   776   1,291   (1,337 ) 44,842  
Other (income) deductions     (302 ) (2,124 ) 1,841   1,221   636  
Early extinguishment of debt     22,501         22,501  
   
 
 
 
 
 
Income (loss) before equity in income of subsidiaries, and income taxes     (86,132 ) 83,492   15,548   (51 ) 12,857  
Equity in income of subsidiaries     95,434       (95,434 )  
Income tax expense (benefit)     (30,430 ) (218 ) 3,773     (26,875 )
   
 
 
 
 
 
Net income   $ 39,732   83,710   11,775   (95,485 ) 39,732  
   
 
 
 
 
 

110



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2003

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
Operating revenues   $   436,777   133,168   (9,034 ) 560,911
Operating expenses       244,255   88,560   (9,003 ) 323,812
Amortization of service contract software       4,913   399     5,312
   
 
 
 
 
  Gross profit       187,609   44,209   (31 ) 231,787

Selling, general and administrative expenses

 

 

20,227

 

47,224

 

12,635

 

(12

)

80,074
Depreciation and amortization     705   32,166   9,502     42,373
   
 
 
 
 
  Operating income (loss)     (20,932 ) 108,219   22,072   (19 ) 109,340
Interest expense     25,629   804   4,085   (4,121 ) 26,397
Other (income) deductions     52   (5,548 ) 2,598   4,082   1,184
Early extinguishment of debt     293         293
   
 
 
 
 
Income (loss) before equity in income of subsidiaries, and income taxes     (46,906 ) 112,963   15,389   20   81,466
Equity in income of subsidiaries     123,369       (123,369 )
Income tax expense     24,316   917   4,086     29,319
   
 
 
 
 
Net income   $ 52,147   112,046   11,303   (123,349 ) 52,147
   
 
 
 
 

111



SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Year Ended December 31, 2001

 
  Parent
Company

  Guarantor
Subsidiaries

  Non-Guarantor
Subsidiaries

  Eliminating
Entries

  Consolidated
 
Net income (loss)   $