UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C.  20549

 

Form 10-Q

 

{Mark One}

 

ý

 

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

 

 

 

 

 

For the quarterly period ended March 31, 2005

 

 

 

 

 

OR

 

 

 

o

 

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

 

 

 

 

 

Commission File number: 0-13063

 

SCIENTIFIC GAMES CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware

 

81-0422894

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

750 Lexington Avenue, New York, New York 10022

(Address of principal executive offices)

(Zip Code)

 

(212) 754-2233

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes  ý     No  o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of May 6, 2005:

Class A Common Stock:  89,097,968

Class B Common Stock:  None

 

 



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND OTHER INFORMATION

 

THREE MONTHS ENDED MARCH 31, 2005

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Consolidated Financial Statements:

 

 

 

 

 

Balance Sheets as of December 31, 2004 and March 31, 2005

 

 

 

 

 

Statements of Income for the Three Months Ended March 31, 2004 and 2005

 

 

 

 

 

Condensed Statements of Cash Flows for the Three Months Ended March 31, 2004 and 2005

 

 

 

 

 

Notes to Consolidated Financial Statements

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

 

 

 

Item 4.

Controls and Procedures

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

Item 3.

Defaults Upon Senior Securities

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

Item 5.

Other Information

 

Item 6.

Exhibits

 

 

2



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share amounts)

 

 

 

December 31,
2004

 

March 31,
2005

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

66,120

 

72,886

 

Short-term investments

 

52,525

 

17,050

 

Accounts receivable, net of allowance for doubtful accounts of $4,818 and $6,133 at December 31, 2004 and March 31, 2005, respectively

 

105,789

 

104,800

 

Inventories

 

28,062

 

32,793

 

Prepaid expenses, deposits and other current assets

 

41,799

 

47,583

 

Total current assets

 

294,295

 

275,112

 

Property and equipment, at cost

 

544,387

 

562,460

 

Less accumulated depreciation

 

272,961

 

279,117

 

Net property and equipment

 

271,426

 

283,343

 

Goodwill, net

 

311,931

 

317,622

 

Operating right, net

 

14,020

 

14,020

 

Other intangible assets, net

 

80,182

 

78,632

 

Other assets and investments

 

120,169

 

118,213

 

Total assets

 

$

1,092,023

 

1,086,942

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current installments of long-term debt

 

$

4,370

 

4,649

 

Accounts payable

 

41,802

 

38,477

 

Accrued liabilities

 

96,999

 

90,461

 

Total current liabilities

 

143,171

 

133,587

 

Other long-term liabilities

 

41,780

 

44,758

 

Long-term debt, excluding current installments

 

606,508

 

583,986

 

Total liabilities

 

791,459

 

762,331

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Class A common stock, par value $0.01 per share, 199,300 shares authorized, 88,414 and 89,076 shares outstanding at December 31, 2004 and March 31, 2005, respectively

 

884

 

891

 

Class B non-voting common stock, par value $0.01 per share, 700 shares authorized, none outstanding

 

 

 

Additional paid-in capital

 

405,755

 

412,181

 

Accumulated losses

 

(108,628

)

(87,613

)

Treasury stock, at cost

 

(9,403

)

(9,403

)

Accumulated other comprehensive income

 

11,956

 

8,555

 

Total stockholders’ equity

 

300,564

 

324,611

 

Total liabilities and stockholders’ equity

 

$

1,092,023

 

1,086,942

 

 

See accompanying notes to consolidated financial statements.

 

3



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Three Months Ended March 31, 2004 and 2005

(Unaudited, in thousands, except per share amounts)

 

 

 

2004

 

2005

 

Operating revenues:

 

 

 

 

 

Services

 

$

141,633

 

155,754

 

Sales

 

43,832

 

28,802

 

 

 

185,465

 

184,556

 

Operating expenses (exclusive of depreciation and amortization shown below):

 

 

 

 

 

Services

 

75,885

 

85,249

 

Sales

 

30,656

 

20,274

 

Amortization of service contract software

 

1,434

 

1,623

 

 

 

107,975

 

107,146

 

Gross profit

 

77,490

 

77,410

 

Selling, general and administrative expenses

 

25,920

 

27,728

 

Depreciation and amortization

 

13,760

 

12,852

 

Operating income

 

37,810

 

36,830

 

Other deductions:

 

 

 

 

 

Interest expense

 

7,390

 

6,410

 

Other expense, net

 

608

 

399

 

 

 

7,998

 

6,809

 

Income before income tax expense

 

29,812

 

30,021

 

Income tax expense

 

9,391

 

9,006

 

Net income

 

20,421

 

21,015

 

Convertible preferred stock dividend

 

1,982

 

 

Net income available to common stockholders

 

$

18,439

 

21,015

 

 

 

 

 

 

 

Basic and diluted net income per share:

 

 

 

 

 

Basic net income available to common stockholders

 

$

0.30

 

0.24

 

Diluted net income available to common stockholders

 

$

0.22

 

0.23

 

 

 

 

 

 

 

Weighted average number of shares used in per share calculations:

 

 

 

 

 

Basic shares

 

61,942

 

88,616

 

Diluted shares

 

91,825

 

91,968

 

 

See accompanying notes to consolidated financial statements.

 

4



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Three Months Ended March 31, 2004 and 2005

(Unaudited, in thousands)

 

 

 

2004

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

20,421

 

21,015

 

 

 

 

 

 

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

15,194

 

14,475

 

Change in deferred income taxes

 

5,999

 

5,322

 

Tax benefit from exercise of employee stock options

 

 

3,549

 

Changes in operating assets and liabilities, net of effects of acquisitions

 

9,810

 

16,312

 

Other

 

652

 

1,473

 

Total adjustments

 

31,655

 

41,131

 

Net cash provided by operating activities

 

52,076

 

62,146

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(6,092

)

(6,154

)

Wagering systems expenditures

 

(13,196

)

(17,134

)

Change in other assets and liabilities, net

 

(5,733

)

(7,792

)

Business acquisitions, net of cash acquired

 

(1,709

)

(2,927

)

Net cash used in investing activities

 

(26,730

)

(34,007

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net repayments under revolving credit facility

 

 

(22,000

)

Proceeds from issuance of long-term debt

 

1,377

 

 

Payments on long-term debt

 

(1,720

)

(473

)

Dividends paid

 

(1,982

)

 

Net proceeds from issuance of common stock

 

3,184

 

2,778

 

Net cash provided by (used in) financing activities

 

859

 

(19,695

)

Effect of exchange rate changes on cash and cash equivalents

 

1,570

 

(1,678

)

Increase in cash and cash equivalents

 

27,775

 

6,766

 

Cash and cash equivalents, beginning of period

 

37,198

 

66,120

 

Cash and cash equivalents, end of period

 

$

64,973

 

72,886

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

9,778

 

2,172

 

Income taxes

 

$

4,503

 

1,709

 

Convertible preferred stock cash dividends

 

$

1,982

 

 

 

See accompanying notes to consolidated financial statements.

 

5



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited, in thousands, except per share amounts)

 

Notes to Consolidated Financial Statements

 

(1)           Consolidated Financial Statements

 

Basis of Presentation

 

The consolidated balance sheet as of March 31, 2005, the consolidated statements of income for the three months ended March 31, 2004 and 2005, and the consolidated condensed statements of cash flows for the three months ended March 31, 2004 and 2005, have been prepared by Scientific Games Corporation (together with its consolidated subsidiaries, “we” or the “Company”) without audit.  In the opinion of management, all adjustments necessary to present fairly the consolidated financial position of the Company at March 31, 2005 and the results of its operations for the three months ended March 31, 2004 and 2005 and its cash flows for the three months ended March 31, 2004 and 2005 have been made.

 

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted.  These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2004 Annual Report on Form 10-K.  The results of operations for the period ended March 31, 2005 are not necessarily indicative of the operating results for the full year.

 

The Company has reclassified $27,600 of Auction Rate Securities from Cash and cash equivalents to Short-term investments at March 31, 2004.  The cash flows from these investments are presented as operating cash flows for all periods presented.

 

Basic and Diluted Net Income Per Share

 

The following represents a reconciliation of the numerator and denominator used in computing basic and diluted net income per share available to common stockholders for the three months ended March 31, 2004 and 2005:

 

 

 

Three months ended March 31,

 

 

 

2004

 

2005

 

Income (numerator)

 

 

 

 

 

Net income available to common stockholders (basic)

 

$

18,439

 

21,015

 

Add back preferred stock dividend

 

1,982

 

 

Income before preferred dividend available to common stockholders (diluted)

 

$

20,421

 

21,015

 

Shares (denominator)

 

 

 

 

 

Basic weighted average common shares outstanding

 

61,942

 

88,616

 

Effect of dilutive securities-stock options, warrants, preferred shares and deferred shares

 

29,883

 

3,352

 

Diluted weighted average common shares outstanding

 

91,825

 

91,968

 

 

 

 

 

 

 

Basic and diluted per share amounts

 

 

 

 

 

Basic net income per share available to common stockholders

 

$

0.30

 

0.24

 

Diluted net income per share available to common stockholders

 

$

0.22

 

0.23

 

 

6



 

The aggregate number of shares that the Company could be obligated to issue upon conversion of its $275,000 0.75% convertible senior subordinated debentures due 2024 (the “Convertible Debentures”), which the Company sold in December 2004, is approximately 9,450. The Convertible Debentures provide for net share settlement upon exercise and the Company has purchased a bond hedge to mitigate the potential dilution from conversion. Such shares were excluded from the quarter ended March 31, 2005 calculation as they were anti-dilutive.  (See Note 9 the Consolidated Financial Statements for the year ended December 31, 2004 in the Company’s 2004 Annual Report on Form 10-K.)

 

Stock-Based Compensation

 

The Company has chosen to continue to account for stock-based compensation using the intrinsic-value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”.  Accordingly, no stock compensation expense has been recognized for a substantial majority of its stock-based compensation plans.  Had the Company elected to recognize compensation cost based on the fair value of the stock options at the date of grant under Statement of Financial Accounting Standards (“SFAS”) No.123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by SFAS No.148, “Accounting for Stock-Based Compensation Transition and Disclosure, an Amendment of FASB Statement No. 123” (“SFAS 148”), such costs would have been recognized ratably over the vesting period of the underlying instruments and the Company’s net income and net income per share would have changed to the pro forma amounts indicated in the table below:

 

 

 

Three months ended March 31,

 

 

 

2004

 

2005

 

 

 

 

 

 

 

Net income available to common stockholders as reported

 

$

18,439

 

$

21,015

 

Add: Stock-based compensation expense included in reported net income, net of related tax effects

 

47

 

51

 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

(1,128

)

(1,871

)

Pro forma net income available to common stockholders

 

$

17,358

 

$

19,195

 

 

 

 

 

 

 

Net income available to common stockholders per basic share:

 

 

 

 

 

As reported

 

$

0.30

 

0.24

 

Pro forma

 

$

0.29

 

0.22

 

Net income available to common stockholders per diluted share:

 

 

 

 

 

As reported

 

$

0.22

 

0.23

 

Pro forma

 

$

0.21

 

0.21

 

 

7



 

(2)           Acquisitions

 

On December 31, 2004, the Company acquired all of the outstanding shares of Printpool Honsel GmbH (“Honsel”), a German company which is the supplier of instant tickets to all of the 16 state operated lotteries in Germany and sells other lottery products, such as bet slips and paper rolls, to customers in approximately 25 countries.  The purchase price was approximately $21,000 in cash and additional amounts of up to approximately $10,500 in cash upon achievement of certain performance levels over the next five years. The operating results of Honsel have been included in the Company’s consolidated operating results since January 1, 2005.  Had the operating results of Honsel been included as if the transaction had been consummated on January 1, 2004, the Company’s pro forma operating results for the quarter ended March 31, 2004 would not have been materially different from the actual reported results.  The preliminary estimate of goodwill of approximately $12,300 from the acquisition of Honsel is not deductible for tax purposes. Additionally, other assets and liabilities acquired in the transaction, such as certain intangible assets, property and equipment, current assets and liabilities and debt were included in the preliminary purchase price allocation.

 

8



 

(3)           Business Segments

 

The following tables represent revenues, profits, depreciation, amortization, and capital expenditures for the three months ended March 31, 2004 and 2005, by business segment.  Corporate expenses, interest expense and other (income) deductions are not allocated to business segments.

 

 

 

Three Months Ended March 31, 2004

 

 

 

Lottery
Group

 

Pari-
Mutuel
Group

 

Venue
Management
Group

 

Telecom-
munications
Products
Group

 

Totals

 

Service revenues

 

$

107,294

 

19,043

 

15,296

 

 

141,633

 

Sales revenues

 

29,565

 

689

 

 

13,578

 

43,832

 

Total revenues

 

136,859

 

19,732

 

15,296

 

13,578

 

185,465

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of service

 

55,010

 

9,994

 

10,881

 

 

75,885

 

Cost of sales

 

20,247

 

409

 

 

10,000

 

30,656

 

Amortization of service contract software

 

793

 

641

 

 

 

1,434

 

 

 

76,050

 

11,044

 

10,881

 

10,000

 

107,975

 

Gross profit

 

60,809

 

8,688

 

4,415

 

3,578

 

77,490

 

Selling, general and administrative expenses

 

16,562

 

1,839

 

1,004

 

1,482

 

20,887

 

Depreciation and amortization

 

9,507

 

2,820

 

490

 

733

 

13,550

 

Segment operating income

 

$

34,740

 

4,029

 

2,921

 

1,363

 

43,053

 

Unallocated corporate expense

 

 

 

 

 

 

 

 

 

5,243

 

Consolidated operating income

 

 

 

 

 

 

 

 

 

$

37,810

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets at March 31, 2004

 

$

568,101

 

84,670

 

35,894

 

45,552

 

734,217

 

Unallocated assets at March 31, 2004

 

 

 

 

 

 

 

 

 

238,557

 

Consolidated assets at March 31, 2004

 

 

 

 

 

 

 

 

 

$

972,774

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

14,461

 

4,333

 

336

 

158

 

19,288

 

 

9



 

 

 

Three Months Ended March 31, 2005

 

 

 

Lottery
Group

 

Pari-
Mutuel
Group

 

Venue
Management
Group

 

Telecom-
munications
Products
Group

 

Totals

 

Service revenues

 

$

123,391

 

18,031

 

14,332

 

 

155,754

 

Sales revenues

 

13,531

 

357

 

 

14,914

 

28,802

 

Total revenues

 

136,922

 

18,388

 

14,332

 

14,914

 

184,556

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of service

 

63,889

 

10,369

 

10,991

 

 

85,249

 

Cost of sales

 

9,329

 

415

 

 

10,530

 

20,274

 

Amortization of service contract software

 

973

 

650

 

 

 

1,623

 

 

 

74,191

 

11,434

 

10,991

 

10,530

 

107,146

 

Gross profit

 

62,731

 

6,954

 

3,341

 

4,384

 

77,410

 

Selling, general and administrative expenses

 

15,614

 

3,041

 

874

 

1,504

 

21,033

 

Depreciation and amortization

 

8,922

 

2,204

 

484

 

967

 

12,577

 

Segment operating income

 

$

38,195

 

1,709

 

1,983

 

1,913

 

43,800

 

Unallocated corporate expense

 

 

 

 

 

 

 

 

 

6,970

 

Consolidated operating income

 

 

 

 

 

 

 

 

 

$

36,830

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets at March 31, 2005

 

$

686,728

 

78,083

 

33,610

 

68,155

 

866,576

 

Unallocated assets at March 31, 2005

 

 

 

 

 

 

 

 

 

220,366

 

Consolidated assets at March 31, 2005

 

 

 

 

 

 

 

 

 

$

1,086,942

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

20,295

 

2,077

 

280

 

636

 

23,288

 

 

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

 

 

 

Three Months Ended March 31,

 

 

 

2004

 

2005

 

Reported consolidated operating income

 

$

37,810

 

36,830

 

Interest expense

 

7,390

 

6,410

 

Other expense, net

 

608

 

399

 

Income before income tax expense

 

$

29,812

 

30,021

 

 

10



 

(4)           Income Tax Expense

 

The effective income tax rate for the three months ended March 31, 2005 of 30.0% differed from the federal statutory rate of 35% due primarily to benefits from the tax restructuring plan implemented in 2004. The effective income tax rate for the three months ended March 31, 2004 was approximately 31.5%, which differed from the federal statutory rate of 35% due primarily to benefits from the realization of foreign tax credits and the implementation of the extra-territorial income exclusion regime.

 

(5)           Comprehensive Income

 

The following presents a reconciliation of net income to comprehensive income for the three-month periods ended March 31, 2004 and 2005:

 

 

 

Three Months Ended
March 31,

 

 

 

2004

 

2005

 

Net income

 

$

20,421

 

21,015

 

Other comprehensive income (loss):

 

 

 

 

 

Foreign currency translation

 

1,384

 

(3,390

)

Unrealized gain (loss) on investments

 

12

 

(11

)

Unrealized gain on Canadian dollar hedges

 

1,107

 

 

Other comprehensive income (loss)

 

2,503

 

(3,401

)

Comprehensive income

 

22,924

 

17,614

 

 

(6)           Inventories

 

Inventories consist of the following:

 

 

 

December 31,
2004

 

March 31,
2005

 

Parts and work-in-process

 

$

18,655

 

22,649

 

Finished goods

 

9,407

 

10,144

 

 

 

$

28,062

 

32,793

 

 

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.

 

11



 

(7)           Accrued Liabilities

 

Accrued liabilities consist of the following:

 

 

 

December 31,
2004

 

March 31,
2005

 

Compensation and benefits

 

$

26,135

 

20,544

 

Customer advances

 

4,579

 

5,324

 

Deferred revenue

 

3,192

 

7,673

 

Accrued contract costs

 

10,958

 

9,654

 

Other

 

52,135

 

47,266

 

 

 

$

96,999

 

90,461

 

 

(8)           Debt

 

At March 31, 2005, the Company had approximately $218,700 available for borrowing under the Company’s revolving credit facility, which was entered into in December 2004, as part of the Company’s senior secured credit facility (the “2004 Facility”).  There were no borrowings outstanding under the revolving credit facility, but approximately $31,300 in letters of credit were issued and outstanding at March 31, 2005.  At December 31, 2004, the Company’s available borrowing capacity under the revolving credit facility was $199,900.  At March 31, 2005, there was $99,750 in outstanding Term Loans under the 2004 Facility.

 

The Credit Agreement governing the 2004 Facility (the “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 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 Credit Agreement contains the following financial covenants that are computed quarterly on a rolling four-quarter basis as applicable:

 

      A maximum Consolidated Leverage Ratio of 3.75, which will be reduced according to the terms of the 2004 Credit Agreement on July 1, 2006, from which date until December 2009 the ratio shall be 3.50.  Consolidated Leverage Ratio means the ratio of (x) the aggregate stated balance sheet amount of the Company’s indebtedness determined on a consolidated basis in accordance with GAAP as of the last day of the fiscal quarter for which such determination is being made to (y) Consolidated EBITDA for the four consecutive fiscal quarters ended on the last day of the fiscal quarter for which such determination is being made.

 

      A minimum Consolidated Fixed Charge Coverage Ratio of 1.00 until December 2009.  Consolidated Fixed Charge Coverage Ratio means, as of any date of determination, the ratio computed for the Company’s four most recent fiscal quarters of (x) Consolidated EBITDA to (y) the sum of (i) total interest expense less non-cash amortization costs included in interest expense, (ii) scheduled payments of principal on indebtedness, (iii) capital expenditures and (iv) all income taxes paid in cash.

 

      A maximum Consolidated Senior Debt Ratio of 2.00, which will be reduced according to the terms of the 2004 Credit Agreement on July 1, 2006, from which date until December 2009 the ratio shall be 1.75.  Consolidated Senior Debt Ratio means the ratio of (x) the aggregate stated balance sheet amount of the Company’s indebtedness, less the amount of the Company’s 12 1/2% senior subordinated notes (the “2000 Notes”), the Company’s 6.25% senior subordinated notes due 2012 (the “2004 Notes”) and the Convertible Debentures determined on a consolidated basis in accordance with GAAP as of the last day of the fiscal quarter for which such determination is being made to (y) Consolidated EBITDA for the four consecutive fiscal quarters ended on the last day of the fiscal quarter for which such determination is being made.

 

12



 

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) provision 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 its loan covenants as of March 31, 2005.

 

(9)           Goodwill and Intangible Assets

 

The following disclosure presents certain information regarding the Company’s acquired intangible assets as of December 31, 2004 and March 31, 2005.  Amortizable 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, 2004

 

 

 

 

 

 

 

 

 

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Patents

 

15

 

$

4,221

 

477

 

3,744

 

Customer lists

 

14

 

20,175

 

7,597

 

12,578

 

Customer service contracts

 

15

 

3,781

 

1,331

 

2,450

 

Licenses

 

15

 

10,377

 

3,315

 

7,062

 

Lottery contracts

 

5

 

31,802

 

7,910

 

23,892

 

 

 

 

 

70,356

 

20,630

 

49,726

 

Non-amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Tradename

 

 

 

32,574

 

2,118

 

30,456

 

Connecticut off-track betting system operating right

 

 

 

22,339

 

8,319

 

14,020

 

 

 

 

 

54,913

 

10,437

 

44,476

 

Total intangible assets

 

 

 

$

125,269

 

31,067

 

94,202

 

 

 

 

 

 

 

 

 

 

 

Balance at March 31, 2005

 

 

 

 

 

 

 

 

 

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Patents

 

15

 

$

4,292

 

541

 

3,751

 

Customer lists

 

14

 

19,744

 

7,941

 

11,803

 

Customer service contracts

 

15

 

3,624

 

1,343

 

2,281

 

Licenses

 

15

 

11,629

 

4,207

 

7,422

 

Lottery contracts

 

5

 

32,200

 

9,281

 

22,919

 

 

 

 

 

71,489

 

23,313

 

48,176

 

Non-amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Tradename

 

 

 

32,574

 

2,118

 

30,456

 

Connecticut off-track betting system operating right

 

 

 

22,339

 

8,319

 

14,020

 

 

 

 

 

54,913

 

10,437

 

44,476

 

Total intangible assets

 

 

 

$

126,402

 

33,750

 

92,652

 

 

13



 

The aggregate intangible amortization expense for the three-month periods ended March 31, 2004 and 2005 was approximately $2,777 and $2,692, respectively.

 

The table below reconciles the change in the carrying amount of goodwill, by reporting unit, which is the same as business segment, for the period from January 1, 2005 to March 31, 2005.  In 2005, the Company recorded (a) a $2,927 increase in goodwill in connection with the acquisition of certain assets and the assumption of certain liabilities from Promo-Travel International, Inc., in February 2005 and (b) a $2,764 increase in goodwill associated with the Honsel acquisition.

 

Goodwill

 

Lottery
Group

 

Pari-
mutuel
Group

 

Venue
Management
Group

 

Telecom-
munications
Products
Group

 

Totals

 

Balance at December 31, 2004

 

$

311,444

 

487

 

 

 

311,931

 

Adjustments:

 

5,691

 

 

 

 

5,691

 

Balance at March 31, 2005

 

$

317,135

 

487

 

 

 

317,622

 

 

(10)         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 regulatory authorities.  The Company estimates that the amount to be funded in year 2005 will approximate $2,500.

 

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. The Company expects to make payments to the multi-employer plan of approximately $250 during the year ending December 31, 2005.

 

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.  The Company has a 401(k) plan for all union employees which does not provide for Company contributions.

 

The Company has an unfunded nonqualified Supplemental Executive Retirement Plan (the “SERP”) and an unfunded nonqualified Deferred Compensation Plan. The SERP provides for retirement benefits for certain senior executives according to a formula based on each participant’s compensation and years of service with the Company and the Deferred Compensation Plan permits salary and bonus deferrals and does not provide for Company contributions.

 

14



 

The following table sets forth the combined amount of net periodic benefit cost recognized for the three month periods ended March 31, 2004 and 2005:

 

 

 

Three Months Ended
March 31,

 

 

 

2004

 

2005

 

Components of net periodic pension benefit cost:

 

 

 

 

 

Service cost

 

$

676

 

814

 

Interest cost

 

641

 

788

 

Expected return on plan assets

 

(448

)

(625

)

Actuarial loss

 

295

 

419

 

Net amortization and deferral

 

13

 

16

 

Amortization of prior service costs

 

192

 

192

 

Net periodic cost

 

$

1,369

 

1,604

 

 

(11)                          Stockholders’ Equity

 

At March 31, 2005, the Company had a total of 2,000 shares of preferred stock, $1.00 par value, authorized for issuance, including 229 authorized shares of Series A Convertible Preferred Stock and 1 authorized share of Series B Preferred Stock. No shares of preferred stock are currently outstanding.

 

In August 2004, holders of all of the Company’s then outstanding Series A Convertible Preferred Stock and Series B Preferred Stock were issued an aggregate of 23,832 shares of the Company’s Class A Common Stock in connection with their conversion, representing a conversion price of $5.56 per share. Prior to conversion, the Series A Convertible Preferred Stock required dividend payments at a rate of 6% per annum. Prior to 2004, we satisfied the dividend requirement using additional shares of convertible preferred stock.  In March 2004 the Company paid a dividend in cash of $1,982.  Prior to 2005, the preferred stock dividend was deducted in determining the amount of the net income available to common stockholders in the consolidated statements of income.

 

(12)                          Litigation

 

On May 9, 2005, Scientific Games Royalty Corporation, a wholly-owned indirect subsidiary of Scientific Games Corporation, filed suit against GTECH Corporation in Federal District Court of Delaware alleging patent infringement of the Company’s group participation multiplier patents, U.S. Patent Nos. 6,648,753 and 6,692,354.  These patents apply to online lottery games that have an optional bonus wager as a feature of the game.  In the event that a player wins a prize in the base game and has chosen to make the bonus wager, all of the player’s prizes in the base game, with the exception of the jackpot amount, may be multiplied by a randomly selected multiplier.   The Company believes that GTECH currently provides such games that infringe the Company’s applicable patents in various jurisdictions in the United States.  The Company’s lawsuit seeks damages and other relief for such infringement.

 

On or about April 6, 2005, the Company was served with a complaint in the Texas state court action captioned GTECH Holdings Corporation and GTECH Corporation v. Scientific Games International, Inc. previously described in our Annual Report on Form 10-K for the year ended December 31, 2004.  The Company continues to believe that the plaintiffs’ claims lack merit and intends to contest them vigorously.

 

(13)                          Subsequent Events

 

In April 2005, the Company acquired the remaining 35% minority interest in Scientific Games Latin America S.A. (“SGLA”), a supplier of lottery tickets, pre-paid phone cards and promotional games in Latin America.  The Company originally acquired a 65% interest in SGLA in June 2002.  Pursuant to the April 2005 transactions, the Company paid approximately $19,600 for the purchase price of the minority interest and additional amounts of approximately $4,300 for the balance of the purchase price for the 2002 acquisition, repayment of a prior loan to the minority shareholders, and the minority shareholders’ pro-rata share of dividends.

 

15



 

The excess of the additional purchase price over the fair value of the net assets acquired will be recorded as goodwill. The operating results of SGLA have been included in the Company’s operating income since the initial acquisition of the 65% interest in 2002, with the minority portion of such earnings included as a deduction in “Other expense”. Beginning in the second quarter of 2005, this deduction will cease. Had this deduction not been made in the first quarter of 2005, the Company’s results of operations would not have been materially different from the actual reported results.

 

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

 

The Company conducts substantially all of its business through its domestic and foreign subsidiaries.  The 2004 Notes, the Convertible Debentures and the 2004 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 non-wholly owned domestic and foreign subsidiaries (the “Non-Guarantor Subsidiaries”) as of December 31, 2004 and March 31, 2005 and for the three months ended March 31, 2004 and 2005.  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, Guarantor Subsidiaries and Non-Guarantor Subsidiaries, assuming the guarantee structure of the 2004 Facility, the Convertible Debentures and the 2004 Notes were in effect at the beginning of the periods presented.  Separate financial statements for 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.  Corporate interest and administrative expenses have not been allocated to the subsidiaries.

 

16



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET

December 31, 2004

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

34,979

 

14,987

 

16,154

 

 

66,120

 

Short-term investments

 

52,525

 

 

 

 

52,525

 

Accounts receivable, net

 

 

73,236

 

32,592

 

(39

)

105,789

 

Inventories

 

 

18,245

 

10,425

 

(608

)

28,062

 

Other current assets

 

11,778

 

17,310

 

12,681

 

30

 

41,799

 

Property and equipment, net

 

5,093

 

206,331

 

60,633

 

(631

)

271,426

 

Investment in subsidiaries

 

771,987

 

187,019

 

(36,563

)

(922,443

)

 

Goodwill

 

183

 

297,000

 

14,748

 

 

311,931

 

Intangible assets

 

 

79,303

 

14,899

 

 

94,202

 

Other assets

 

53,095

 

59,522

 

15,777

 

(8,225

)

120,169

 

Total assets

 

$

929,640

 

952,953

 

141,346

 

(931,916

)

1,092,023

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Current installments of long-term debt

 

$

1,000

 

 

3,370

 

 

4,370

 

Current liabilities

 

8,672

 

91,503

 

37,426

 

1,200

 

138,801

 

Long-term debt, excluding current installments

 

603,645

 

 

2,863

 

 

606,508

 

Other non-current liabilities

 

(5,486

)

30,503

 

16,699

 

64

 

41,780

 

Intercompany balances

 

(124,873

)

108,969

 

17,948

 

(2,044

)

 

Stockholders’ equity

 

446,682

 

721,978

 

63,040

 

(931,136

)

300,564

 

Total liabilities and stockholders’ equity

 

$

929,640

 

952,953

 

141,346

 

(931,916

)

1,092,023

 

 

17



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET

March 31, 2005

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

27,010

 

818

 

45,058

 

 

72,886

 

Short-term investments

 

17,050

 

 

 

 

17,050

 

Accounts receivable, net

 

 

71,999

 

32,840

 

(39

)

104,800

 

Inventories

 

 

19,801

 

13,417

 

(425

)

32,793

 

Other current assets

 

10,962

 

18,991

 

17,600

 

30

 

47,583

 

Property and equipment, net

 

4,933

 

212,156

 

66,884

 

(630

)

283,343

 

Investment in subsidiaries

 

768,826

 

187,263

 

(36,363

)

(919,726

)

 

Goodwill

 

183

 

299,927

 

17,512

 

 

317,622

 

Intangible assets

 

 

78,263

 

14,389

 

 

92,652

 

Other assets

 

48,936

 

58,182

 

17,131

 

(6,036

)

118,213

 

Total assets

 

$

877,900

 

947,400

 

188,468

 

(926,826

)

1,086,942

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Current installments of long-term debt

 

$

1,000

 

 

3,649

 

 

4,649

 

Current liabilities

 

5,464

 

81,928

 

41,568

 

(22

)

128,938

 

Long-term debt, excluding current installments

 

581,395

 

 

2,591

 

 

583,986

 

Other non-current liabilities

 

(3,503

)

30,699

 

17,556

 

6

 

44,758

 

Intercompany balances

 

(135,335

)

96,098

 

38,580

 

657

 

 

Stockholders’ equity

 

428,879

 

738,675

 

84,524

 

(927,467

)

324,611

 

Total liabilities and stockholders’ equity

 

$

877,900

 

947,400

 

188,468

 

(926,826

)

1,086,942

 

 

18



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED STATEMENT OF INCOME

Three Months Ended March 31, 2004

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

Operating revenues

 

$

 

153,902

 

33,840

 

(2,277

)

185,465

 

Operating expenses

 

 

85,266

 

23,569

 

(2,294

)

106,541

 

Amortization of service contract software

 

 

1,334

 

100

 

 

1,434

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

 

67,302

 

10,171

 

17

 

77,490

 

Selling, general and administrative expenses

 

5,033

 

16,845

 

4,045

 

(3

)

25,920

 

Depreciation and amortization

 

210

 

11,100

 

2,450

 

 

13,760

 

Operating income (loss)

 

(5,243

)

39,357

 

3,676

 

20

 

37,810

 

Interest expense

 

7,154

 

219

 

1,139

 

(1,122

)

7,390

 

Other (income) expense

 

(275

)

(1,359

)

1,120

 

1,122

 

608

 

Income (loss) before equity in income of subsidiaries, and income taxes

 

(12,122

)

40,497

 

1,417

 

20

 

29,812

 

Equity in income of subsidiaries

 

39,501

 

 

 

(39,501

)

 

Income tax expense

 

6,958

 

1,923

 

510

 

 

9,391

 

Net income

 

$

20,421

 

38,574

 

907

 

(39,481

)

20,421

 

 

 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED STATEMENT OF INCOME

Three Months Ended March 31, 2005

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

Operating revenues

 

$

 

141,942

 

45,104

 

(2,490

)

184,556

 

Operating expenses

 

 

77,506

 

30,603

 

(2,586

)

105,523

 

Amortization of service contract software

 

 

1,620

 

3

 

 

1,623

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

 

62,816

 

14,498

 

96

 

77,410

 

Selling, general and administrative expenses

 

6,639

 

16,248

 

4,861

 

(20

)

27,728

 

Depreciation and amortization

 

275

 

9,272

 

3,305

 

 

12,852

 

Operating income (loss)

 

(6,914

)

37,296

 

6,332

 

116

 

36,830

 

Interest expense

 

6,197

 

107

 

106

 

 

6,410

 

Other (income) expense

 

(277

)

155

 

(127

)

648

 

399

 

Income (loss) before equity in income of subsidiaries, and income taxes

 

(12,834

)

37,034

 

6,353

 

(532

)

30,021

 

Equity in income of subsidiaries

 

40,381

 

 

 

(40,381

)

 

Income tax expense

 

6,532

 

1,237

 

1,237

 

 

9,006

 

Net income (loss)

 

$

21,015

 

35,797

 

5,116

 

(40,913

)

21,015

 

 

19



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED STATEMENT OF CASH FLOWS

Three Months Ended March 31, 2004

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

Net income

 

$

20,421

 

38,574

 

907

 

(39,481

)

20,421

 

Depreciation and amortization

 

210

 

12,434

 

2,550

 

 

15,194

 

Deferred income taxes

 

6,221

 

(395

)

173

 

 

5,999

 

Equity in income of subsidiaries

 

(39,501

)

 

 

39,501

 

 

Changes in operating assets and liabilities, net of effects of acquisitions

 

8,590

 

6,188

 

(5,030

)

62

 

9,810

 

Other non-cash adjustments

 

566

 

86

 

 

 

652

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

(3,493

)

56,887

 

(1,400

)

82

 

52,076

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

(18

)

(16,072

)

(3,198

)

 

(19,288

)

Business acquisitions, net of cash acquired

 

 

(1,709

)

 

 

(1,709

)

Other assets and investments

 

(308

)

(5,692

)

(1,422

)

1,689

 

(5,733

)

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

(326

)

(23,473

)

(4,620

)

1,689

 

(26,730

)

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

 

 

Net payments on long-term debt

 

(1,259

)

(293

)

1,209

 

 

(343

)

Net proceeds from issuance of common stock

 

3,184

 

1,709

 

 

(1,709

)

3,184

 

Preferred stock dividends

 

(1,982

)

 

 

 

(1,982

)

Other, principally intercompany balances

 

28,461

 

(32,412

)

4,013

 

(62

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

28,404

 

(30,996

)

5,222

 

(1,771

)

859

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

1,020

 

52

 

498

 

 

1,570

 

 

 

 

 

 

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

25,605

 

2,470

 

(300

)

 

27,775

 

Cash and cash equivalents, beginning of period

 

25,443

 

(4,473

)

16,228

 

 

37,198

 

Cash and cash equivalents, end of period

 

$

51,048

 

(2,003

)

15,928

 

 

64,973

 

 

20



 

SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL CONDENSED STATEMENT OF CASH FLOWS

Three Months Ended March 31, 2005

(unaudited, in thousands)

 

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminating
Entries

 

Consolidated

 

Net income

 

$

21,015

 

35,797

 

5,116

 

(40,913

)

21,015

 

Depreciation and amortization

 

275

 

10,892

 

3,308

 

 

14,475

 

Deferred income taxes

 

4,357

 

(396

)

1,361

 

 

5,322

 

Equity in income of subsidiaries

 

(40,381

)

 

 

40,381

 

 

Changes in operating assets and liabilities, net of effects of acquisitions

 

36,738

 

(10,809

)

(5,014

)

(1,054

)

19,861

 

Other

 

888

 

581

 

4

 

 

1,473

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

22,892

 

36,065

 

4,775

 

(1,586

)

62,146

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

(8

)

(12,467

)

(10,813

)

 

(23,288

)

Business acquisitions, net of cash acquired

 

 

(2,927

)

 

 

(2,927

)

Other assets and investments

 

790

 

(4,783

)

(4,427

)

628

 

(7,792

)

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

782

 

(20,177

)

(15,240

)

628

 

(34,007

)

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

 

 

Net payments on long-term debt

 

(22,250

)

 

(223

)

 

(22,473

)

Net proceeds from issuance of common stock

 

2,778

 

 

648

 

(648

)

2,778

 

Preferred stock dividends

 

 

 

 

 

 

Other, principally intercompany balances

 

(11,878

)

(21,463

)

41,195

 

(7,854

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

(31,350

)

(21,463

)

41,620

 

(8,502

)

(19,695

)

 

 

 

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(293

)

(143

)

(10,702

)

9,460

 

(1,678

)

 

 

 

 

 

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

(7,969

)

(5,718

)

20,453

 

 

6,766

 

Cash and cash equivalents, beginning of period

 

34,979

 

6,536

 

24,605

 

 

66,120

 

Cash and cash equivalents, end of period

 

$

27,010

 

818

 

45,058

 

 

72,886

 

 

21



 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Background

 

The following discussion addresses our financial condition as of March 31, 2005 and the results of our operations for the three months ended March 31, 2005, compared to the corresponding period in the prior year. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2004, included in our 2004 Annual Report on Form 10-K.

 

We operate in four business segments: Lottery Group, Pari-mutuel Group, Venue Management Group and Telecommunications Products Group. 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. Additionally, this division provides lotteries with over 80 licensed brand products, including NASCAR®, Mandalay Bay®, National Basketball Association®, Harley-Davidson®, Wheel-of-Fortune®, Hasbro®, Corvette® and The World Series of Poker®.  This division also 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 online 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 also includes software and hardware and support services for sports betting and operation of credit card processing systems.

 

On December 31, 2004, we acquired Printpool Honsel GmbH (“Honsel”), a German company which is the supplier of instant lottery tickets to all of the 16 state operated lotteries in Germany and sells other lottery products, such as bet slips and paper rolls, to customers in approximately 25 countries.  We expect that our acquisition of Honsel will enable us to further expand into the European lottery market.

 

Our Pari-mutuel Group is comprised of our North American and international on-track, off-track and inter-track pari-mutuel wagering services, simulcasting and communications services, and telephone and internet account wagering systems, as well as sales of pari-mutuel systems and equipment.

 

Our Venue Management Group is comprised of our Connecticut off-track betting operations, which include 11 off-track betting facilities and telephone account wagering for customers in 26 states, and our on-track and off-track betting operations in the Netherlands, which consist of four on-track and 28 off-track betting operations.

 

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

 

The first and fourth quarters of the calendar year traditionally comprise the weakest season for our pari-mutuel wagering business. 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 and lottery 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 licensing transactions. In addition, instant ticket and prepaid phone card sales may vary depending on the season and timing of contract awards, changes in customer budgets, inventory ticket 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.

 

22



 

Results of Operations: See Note 3—Business Segments

 

Three Months Ended March 31, 2005 compared to Three Months Ended March 31, 2004

 

Revenue Analysis

 

For the quarter ended March 31, 2005, revenues of $184.6 million were down $0.9 million or 0.5% as compared to the prior year quarter, due to a $15.0 million or 34% decrease in sales revenue which was largely offset by a $14.1 million or 10% increase in service revenue.

 

The increase in service revenue in the quarter ended March 31, 2005 is primarily attributable to a $16.1 million or 15% increase in service revenues in the Lottery Group which results from to continued strong sales of instant lottery tickets and licensed game properties, partially offset by approximately $6.1 million of lower revenues on the Florida lottery contract which ended in January 2005. Pari-mutuel Group service revenues decreased $1.0 million, reflecting lower wagering, and the loss of the New York Racing Association contract. Venue Management Group service revenues decreased $1.0 million due to lower wagering, in part because of the smoking ban instituted in Connecticut in the second quarter of 2004.

 

The $15.0 million decrease in sales revenue in the quarter ended March 31, 2005 is primarily attributable to $16.0 million of non-recurring systems and equipment sales in the Lottery Group and a $0.3 million of non-recurring system and equipment sales in the Pari-mutuel Group, partially offset by a $1.3 million improvement in revenues in the Telecommunications Products Group, due primarily to higher sales volume and favorable foreign exchange rates, partially offset by lower prices.

 

Gross Profit Analysis

 

Gross profit of $77.4 million for the quarter ended March 31, 2005 decreased $0.1 million as compared to the corresponding period in 2004, due to a $4.6 million decrease in sales revenue margins which was mostly offset by a $4.5 million or 7% improvement in service revenue gross margins. Gross margins were 42% in 2005 and 2004. The $1.9 million increase in the Lottery Group gross profit related to higher service revenues. The $1.4 million or 17% decrease in services revenue margins in the Pari-mutuel Group reflects the result of lower service revenues and increases in operating costs. Venue Management Group gross profit decreased $1.1 million or 24% as a result of lower service revenues. Telecommunications Products Group gross profit increased $0.8 million or 23% from the prior year as a result of higher sales revenues, as described above.

 

Expense Analysis

 

Selling, general and administrative expenses of $27.7 million for the quarter ended March 31, 2005 were $1.8 million or 7% higher than in 2004.  This increase is primarily due to increased sales and marketing costs, compensation and professional service fees.

 

Depreciation and amortization expense, including amortization of service contract software, of $14.5 million for the quarter ended March 31, 2005 decreased $0.7 million or 5% from the corresponding period in 2004.  Interest expense of $6.4 million for the quarter ended March 31, 2005 decreased $1.0 million or 13% from 2004, primarily reflecting the benefits of the debt restructuring completed in December 2004, partially offset by additional borrowings outstanding during the quarter.

 

Income Tax Expense

 

Income tax expense of $9.0 million for the quarter ended March 31, 2005 decreased $0.4 million or 4% from 2004. The financial statement income tax provision was 30.0% in 2005 and 31.5% in 2004. The lower effective rate in 2005 primarily reflects the benefits from the tax restructuring plan implemented in 2004.

 

23



 

Critical Accounting Policies

 

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by the application of our accounting policies. Our significant accounting policies are described in Note 1 to our 2004 Annual Report on Form 10-K. Critical accounting policies are those that require application of management’s most difficult, subjective, or complex judgments, often as a result of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies for us include revenue recognition on percentage of completion contracts related to lottery development projects and pari-mutuel systems software development projects, capitalization of software development costs, evaluation of the recoverability of assets, the assessment of litigation and contingencies, accounting for stock-based compensation, accounting for derivative instruments and hedging activities, and accounting for income and other taxes. Actual results could differ from estimates.

 

Liquidity, Capital Resources and Working Capital

 

As of March 31, 2005, our senior secured credit facility (the “2004 Facility”) consists of a $250.0 million revolving credit facility due 2009 and a $99.8 million Term Loan B due 2009. The 2004 Facility contains certain financial covenants which are described below. At March 31, 2005, approximately 18% of our debt, representing approximately $105.7 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 interest rates associated with our unhedged variable rate debt will result in a change of approximately $0.1 million per year in our interest expense assuming no change in our outstanding borrowings.

 

Our financing arrangements as of March 31, 2005 impose certain limitations on our and our subsidiaries’ operations.

 

The credit agreement governing the 2004 Facility (the “2004 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 2004 Credit Agreement contains the following financial covenants, which are computed quarterly on a rolling four-quarter basis as applicable:

 

 A maximum Consolidated Leverage Ratio of 3.75, which will be reduced according to the terms of the 2004 Credit Agreement on July 1, 2006, from which date until December 2009 the ratio shall be 3.50.  Consolidated Leverage Ratio means the ratio of (x) the aggregate stated balance sheet amount of our indebtedness determined on a consolidated basis in accordance with GAAP as of the last day of the fiscal quarter for which such determination is being made to (y) Consolidated EBITDA for the four consecutive fiscal quarters ended on the last day of the fiscal quarter for which such determination is being made.

 

  A minimum Consolidated Fixed Charge Coverage Ratio of 1.00 until December 2009. Consolidated Fixed Charge Coverage Ratio means, as of any date of determination, the ratio computed for our four most recent fiscal quarters of (x) Consolidated EBITDA to (y) the sum of (i) total interest expense less non-cash amortization costs included in interest expense, (ii) scheduled payments of principal on indebtedness, (iii) capital expenditures and (iv) all income taxes paid in cash.

 

  A maximum Consolidated Senior Debt Ratio of 2.00, which will be reduced according to the terms of the 2004 Credit Agreement on July 1, 2006, from which date until December 2009 the ratio shall be 1.75. Consolidated Senior Debt Ratio means the ratio of (x) the aggregate stated balance sheet amount of our indebtedness, less the amount of the 2000 Notes, the 2004 Notes and the Convertible Debentures, determined on a consolidated basis in accordance with GAAP as of the last day of the fiscal quarter for which such determination is being made to (y) Consolidated EBITDA for the four consecutive fiscal quarters ended on the last day of the fiscal quarter for which such determination is being made.

 

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 March 31, 2005 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.

 

24



 

At March 31, 2005, we had outstanding letters of credit of $31.3 million, but no outstanding borrowings under the revolving credit facility, leaving us with a total availability of $218.7 million as compared to $199.9 million at December 31, 2004. Our ability to borrow under the 2004 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.

 

In August 2004, the holders of our Series A Convertible Preferred Stock converted all outstanding shares into shares of our Class A Common Stock and we redeemed their holdings of our Series B Preferred Stock for a nominal amount.  Prior to conversion, our Series A Convertible Preferred Stock required dividend payments at a rate of 6% per annum. Prior to 2004, we satisfied the dividend requirement using additional shares of convertible preferred stock.   From March 2004 until conversion in August 2004, we paid the dividend in cash.

 

Our pari-mutuel wagering and online 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 income. Historically, the revenues we derive from our pari-mutuel wagering and lottery systems service contracts have exceeded the direct costs associated with fulfilling our obligations thereunder. We expect that we will continue to realize positive cash flow and operating 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 online 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 borrow 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 2005, we anticipate that capital expenditures and software expenditures will be approximately $90.0 million. However, the actual level of expenditures in fiscal year 2005 and beyond will ultimately 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 to service our installed base, we purchase inventory on an as-needed basis. We presently have no inventory purchase obligations.

 

At March 31, 2005, our available cash, short-term investments and borrowing capacity totaled $308.6 million compared to $318.6 million at December 31, 2004. The amount of our available cash and short-term investments fluctuates principally based on the timing of collections from our customers, cash expenditures associated with new and existing pari-mutuel wagering and lottery systems contracts, borrowings or repayments under our credit facilities and changes in our working capital position. The increase in our available cash from the December 31, 2004 level principally reflects the net cash provided by operating activities for the three months ended March 31, 2005 of $62.1 million, partially offset by wagering and other capital expenditures of $31.1 million and acquisition related payments of $2.9 million.  The $62.1 million of net cash provided by operating activities is derived from net cash provided by operations of $45.8 million plus $16.3 million funded from changes in working capital. The working capital changes occurred principally from decreases in short-term investments, partially offset by increases in inventories and other current assets and decreases in accounts payable and accrued liabilities. Capital expenditures of $6.2 million in the first quarter of 2005 are comparable to similar expenditures totaling $6.1 million in the corresponding period in 2004. Wagering system expenditures, including software expenditures, totaled $21.2 million in the first quarter of 2005 compared to $13.9 million in the corresponding period in 2004. This increase is primarily due to the new lottery contract in Puerto Rico. Cash flow from financing activities principally reflects the repayments of borrowings under our 2004 Facility.

 

We believe that our cash flow from operations, available cash and available borrowing capacity under the 2004 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

 

25