UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C.  20549

Form 10-Q

{Mark One}

x

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

 

 

 

For the quarterly period ended September 30, 2006

 

 

 

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

 

81-0422894

(State or other jurisdiction of

 

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

incorporation or organization)

 

 

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 x      No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x                    Accelerated filer  o                    Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o     No x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of November 7, 2006:

Class A Common Stock:  91,608,161

Class B Common Stock:  None

 




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND OTHER INFORMATION

THREE MONTHS ENDED SEPTEMBER 30, 2006

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Consolidated Financial Statements:

 

 

 

 

 

Balance Sheets as of December 31, 2005 and September 30, 2006

 

 

 

 

 

Statements of Income for the Three Months Ended September 30, 2005 and 2006

 

 

 

 

 

Statements of Income for the Nine Months Ended September 30, 2005 and 2006

 

 

 

 

 

Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2006

 

 

 

 

 

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 2

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

 

Item 6.

Exhibits

 

 

2




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share amounts)

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

38,942

 

37,817

 

Accounts receivable, net of allowance for doubtful accounts of $6,149 and $7,062 at December 31, 2005 and September 30, 2006, respectively

 

129,250

 

162,003

 

Inventories

 

40,148

 

63,877

 

Deferred income taxes

 

14,242

 

23,018

 

Prepaid expenses, deposits and other current assets

 

31,971

 

44,810

 

Total current assets

 

254,553

 

331,525

 

Property and equipment, at cost

 

666,469

 

775,108

 

Less accumulated depreciation

 

300,250

 

342,691

 

Net property and equipment

 

366,219

 

432,417

 

Goodwill, net

 

339,169

 

574,782

 

Other intangible assets, net

 

87,289

 

138,359

 

Other assets and investments

 

125,283

 

152,140

 

Total assets

 

$

1,172,513

 

1,629,223

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current installments of long-term debt

 

$

6,055

 

3,256

 

Accounts payable

 

54,223

 

47,776

 

Accrued liabilities

 

80,305

 

118,623

 

Interest payable

 

779

 

5,078

 

Total current liabilities

 

141,362

 

174,733

 

Deferred income taxes

 

9,759

 

8,249

 

Other long-term liabilities

 

59,879

 

68,290

 

Long-term debt, excluding current installments

 

574,680

 

878,515

 

Total liabilities

 

785,680

 

1,129,787

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Class A common stock, par value $0.01 per share, 199,300 shares authorized, 89,869 and 91,434 shares outstanding at December 31, 2005 and September 30, 2006, respectively

 

899

 

914

 

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

 

 

 

Additional paid-in capital

 

425,750

 

457,205

 

Accumulated earnings (losses)

 

(33,309

)

25,565

 

Treasury stock, at cost

 

(9,556

)

(9,556

)

Accumulated other comprehensive income

 

3,049

 

25,308

 

Total stockholders’ equity

 

386,833

 

499,436

 

Total liabilities and stockholders’ equity

 

$

1,172,513

 

1,629,223

 

 

See accompanying notes to consolidated financial statements.

3




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Three Months Ended September 30, 2005 and 2006
(Unaudited, in thousands, except per share amounts)

 

 

2005

 

2006

 

Operating revenues:

 

 

 

 

 

Services

 

$

155,925

 

198,921

 

Sales

 

40,899

 

18,469

 

 

 

196,824

 

217,390

 

Operating expenses

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

86,956

 

107,265

 

Cost of sales (exclusive of depreciation and amortization)

 

30,064

 

13,406

 

Selling, general and administrative expenses

 

31,489

 

34,676

 

Depreciation and amortization

 

17,130

 

36,424

 

Operating income

 

31,185

 

25,619

 

Other deductions:

 

 

 

 

 

Interest expense

 

7,139

 

12,154

 

Equity in net (income) loss in joint ventures

 

60

 

(1,722

)

Other (income) loss, net

 

(530

)

10

 

 

 

6,669

 

10,442

 

Income before income tax expense

 

24,516

 

15,177

 

Income tax expense

 

5,331

 

3,650

 

Net income

 

$

19,185

 

11,527

 

 

 

 

 

 

 

Basic and diluted net income per share:

 

 

 

 

 

Basic net income available to common stockholders

 

$

0.21

 

0.13

 

Diluted net income available to common stockholders

 

$

0.21

 

0.12

 

 

 

 

 

 

 

Weighted average number of shares used in per share calculations:

 

 

 

 

 

Basic shares

 

89,689

 

91,346

 

Diluted shares

 

92,890

 

94,433

 

See accompanying notes to consolidated financial statements.

4




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Nine Months Ended September 30, 2005 and 2006
(Unaudited, in thousands, except per share amounts)

 

 

2005

 

2006

 

Operating revenues:

 

 

 

 

 

Services

 

$

472,546

 

590,113

 

Sales

 

106,258

 

75,043

 

 

 

578,804

 

665,156

 

Operating expenses

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

259,637

 

320,808

 

Cost of sales (exclusive of depreciation and amortization)

 

75,841

 

57,198

 

Selling, general and administrative expenses

 

84,942

 

102,414

 

Depreciation and amortization

 

48,724

 

79,241

 

Operating income

 

109,660

 

105,495

 

Other deductions:

 

 

 

 

 

Interest expense

 

20,361

 

30,471

 

Equity in net (income) loss in joint ventures

 

1,558

 

(6,455

)

Other income, net

 

(1,252

)

(859

)

 

 

20,667

 

23,157

 

Income before income tax expense

 

88,993

 

82,338

 

Income tax expense

 

24,029

 

23,464

 

Net income

 

$

64,964

 

58,874

 

 

 

 

 

 

 

Basic and diluted net income per share:

 

 

 

 

 

Basic net income available to common stockholders

 

$

0.73

 

0.65

 

Diluted net income available to common stockholders

 

$

0.70

 

0.62

 

 

 

 

 

 

 

Weighted average number of shares used in per share calculations:

 

 

 

 

 

Basic shares

 

89,118

 

90,909

 

Diluted shares

 

92,293

 

94,795

 

See accompanying notes to consolidated financial statements.

5




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2005 and 2006
(Unaudited, in thousands)

 

 

2005

 

2006

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

64,964

 

58,874

 

 

 

 

 

 

 

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

 

 

 

 

 

Depreciation and amortization

 

48,724

 

79,241

 

Change in deferred income taxes

 

2,802

 

(7,423

)

Share-based compensation

 

 

14,035

 

Tax benefit from exercise of employee stock options

 

7,295

 

 

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

 

(31,927

)

(38,494

)

Change in short-term investments

 

47,475

 

 

Other

 

9,439

 

(2,697

)

Net cash provided by operating activities

 

148,772

 

103,536

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(14,426

)

(12,360

)

Wagering systems expenditures

 

(72,391

)

(96,777

)

Other intangible assets and software expenditures

 

(13,571

)

(33,012

)

Change in other assets and liabilities, net

 

(12,509

)

(18,006

)

Business acquisitions, net of cash acquired

 

(24,774

)

(263,659

)

Net cash used in investing activities

 

(137,671

)

(423,814

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Borrowings (repayments) under revolving credit facility

 

(22,750

)

155,500

 

Borrowings (repayments) of long-term debt

 

(6,377

)

145,392

 

Excess tax benefit from equity-based compensation plan

 

 

4,487

 

Net proceeds from issuance of common stock

 

6,803

 

12,607

 

Net cash provided by (used in) financing activities

 

(22,324

)

317,986

 

Effect of exchange rate changes on cash and cash equivalents

 

(4,466

)

1,167

 

Increase (decrease) in cash and cash equivalents

 

(15,689

)

(1,125

)

Cash and cash equivalents, beginning of period

 

66,120

 

38,942

 

Cash and cash equivalents, end of period

 

$

50,431

 

37,817

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

13,579

 

24,304

 

Income taxes, net of refunds

 

$

2,394

 

26,618

 

See accompanying notes to consolidated financial statements.

6




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 September 30, 2006, the consolidated statements of income for the three and nine months ended September 30, 2005 and 2006, and the consolidated condensed statements of cash flows for the nine months ended September 30, 2005 and 2006, have been prepared by Scientific Games Corporation (together with its consolidated subsidiaries, the “Company”) without audit.  In the opinion of management, all adjustments necessary to present fairly the consolidated financial position of the Company at September 30, 2006 and the results of its operations for the three and nine months ended September 30, 2005 and 2006 and its cash flows for the nine months ended September 30, 2005 and 2006 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 2005 Annual Report on Form 10-K.  The results of operations for the period ended September 30, 2006 are not necessarily indicative of the operating results for the full year.

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 and nine months ended September 30, 2005 and 2006:

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Income (numerator)

 

 

 

 

 

 

 

 

 

Net income (basic)

 

$

19,185

 

11,527

 

$

64,964

 

58,874

 

Shares (denominator)

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

$

89,689

 

91,346

 

89,118

 

90,909

 

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

 

3,201

 

2,409

 

3,175

 

2,719

 

Effect of dilutive shares related to convertible debentures

 

 

678

 

 

1,167

 

Diluted weighted average common shares outstanding

 

$

92,890

 

94,433

 

92,293

 

94,795

 

 

 

 

 

 

 

 

 

 

 

Basic and diluted per share amounts

 

 

 

 

 

 

 

 

 

Basic net income per share available to common stockholders

 

$

0.21

 

0.13

 

$

0.73

 

0.65

 

Diluted net income per share available to common stockholders

 

$

0.21

 

0.12

 

$

0.70

 

0.62

 

The weighted-average diluted shares outstanding for the three- and nine-month periods ended September 30, 2006 excludes the effect of approximately 553,043 and 87,903 out-of-the-money options, respectively, as their effect would be anti-dilutive. The weighted-average diluted common shares outstanding for the three- and nine-month periods ended September 30, 2005, excludes the effect of approximately 40,434 and 405,020 out-of-the-money, respectively, as their effect would be anti-dilutive.

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 economic dilution from conversion. During the second and third quarters of 2006, the average price of the Company’s common stock exceeded the specified conversion price. For the three and nine months ended September 30, 2006, the Company has included 678 and 1,167 shares, respectively, related to its Convertible Debentures in its diluted weighted average common shares outstanding.  Such

7




shares were excluded from the three and nine months ended September 30, 2005 calculation, as they were anti-dilutive.  The Company has not included the offset from the bond hedge as it would be anti-dilutive; however, when the Convertible Debentures mature, the diluted share amount will decrease because the bond hedge will offset the economic dilution from conversion.

(2)    Acquisitions

On April 20, 2006, the Company acquired The Global Draw Limited and certain related companies (“Global Draw”).  Global Draw is a leading United Kingdom supplier of fixed odds betting terminals and systems, and interactive sports betting systems and also operates terminals and betting systems in Austria and the United Kingdom. The Company expects that the acquisition of Global Draw will strengthen its role in the worldwide sports betting and video lottery business. The purchase price was approximately $183 million (subject to adjustment), plus an earn-out to the selling shareholders, as well as contingent bonuses to certain members of the management team, based on the future financial performance of the business.  The aggregate amount of such payments would total one-third of an amount equal to Global Draw’s EBITDA (EBITDA, for such purposes, is defined as the consolidated earnings before interest, tax, depreciation and amortization) for the year ended December 31, 2008 multiplied by a specific price multiple depending on the level of EBITDA earned. In accordance with current accounting standards, any such payments made to selling shareholders will be capitalized as additional purchase price and any such payments made to management will be expensed. The acquisition was recorded using the purchase method of accounting.  Approximately $2 million of the preliminary estimate of goodwill of approximately $152 million from the acquisition of Global Draw is deductible for tax purposes.  All other assets and liabilities acquired in the transaction were included in the preliminary purchase price allocation.  The Company financed the acquisition through a combination of borrowings under its existing revolving credit facility and a new $100,000 term loan. The operating results of Global Draw have been included in the Company’s Diversified Gaming segment since the beginning of the second quarter of 2006.  The following table represents the unaudited pro forma results of operations for the three and nine months ended September 30, 2005 and 2006 as if the transaction had occurred at the beginning of the periods presented.

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Operating revenues

 

$

214,657

 

217,390

 

$

642,764

 

710,607

 

Operating income

 

$

36,130

 

25,619

 

$

135,640

 

128,635

 

Net income

 

$

21,071

 

11,527

 

$

78,384

 

73,507

 

Basic net income per share

 

$

0.24

 

0.13

 

$

0.88

 

0.81

 

Diluted net income per share

 

$

0.23

 

0.12

 

$

0.85

 

0.78

 

 

These pro forma results have been prepared for comparative purpose and do not purport to be indicative of what would have occurred had the acquisition been consummated on January 1, 2005, or the results that may occur in the future.

On April 5, 2006, the Company acquired certain assets of The Shoreline Star Greyhound Park and Simulcast Facility (“Shoreline”) located in Bridgeport, Connecticut. The Company expects that the acquisition of Shoreline will allow it to maximize the potential of its Connecticut operations. Additionally, the deal eliminates existing restrictions on the Company’s ability to simulcast live racing in certain portions of the state.  The purchase price was approximately $12 million (subject to adjustment) plus an earn-out, based on the future financial performance of the business.  The Company paid cash for the acquisition which was recorded using the purchase method of accounting.  The operating results of Shoreline are included in the Diversified Gaming segment and have been included in the Company’s Statement of Operations since the date of acquisition. The acquisition of Shoreline was not material to the Company’s operations.

On March 22, 2006, the Company acquired substantially all of the online lottery assets of Swedish firm EssNet AB (“EssNet”) which specializes in online lottery systems and terminals to run online lotteries, sports betting, instant tickets and mobile games on a national level. EssNet’s lottery customers include seven states in Germany, the national lottery of Norway, Golden Casket and Tattersall’s Lottery in Australia, and other national lotteries.  The Company expects that its acquisition of EssNet will enable it to further expand into the European lottery market.  The purchase price was approximately $60 million in cash.  The acquisition was recorded using the purchase method of accounting.  The operating results of EssNet are included in the Lottery Systems segment and have been included in the Company’s Statements of Operations since the date of acquisition.  Approximately $55 million of the preliminary estimate of goodwill of approximately $75 million from the acquisition of EssNet is deductible for tax

8




purposes. Additionally, other assets and liabilities acquired in the transaction, such as certain intangible assets, property and equipment, current assets and liabilities were included in the preliminary purchase price allocation.  The acquisition of EssNet was not material to the Company’s operations.

 In conjunction with the purchase of EssNet, the Company has a plan to integrate certain operating locations as part of the integration of EssNet.  The Company has recorded approximately $27 million in liabilities, primarily related to involuntary employee terminations, termination of leases and termination of service contracts that will result from the integration.

The table below summarizes the payments made to date, adjustments and the balance of the accrued integration costs as of and for the period ended September 30, 2006 (in thousands):

Cost Summary

 

Accrued 
Costs at 
Closing

 

Payments

 

Adjustments 
to Goodwill

 

Accrued 
Balance 
September 30, 
2006

 

Severance pay and benefits

 

17,644

 

(5,245

)

(6,163

)

6,236

 

Lease termination

 

1,475

 

(501

)

 

974

 

Contractual obligations

 

7,598

 

(4,111

)

2,653

 

6,140

 

 

 

26,717

 

(9,857

)

(3,510

)

13,350

 

 

In the third quarter of 2006, the Company received an extension to the term of its option to acquire 69% of the shares of International Lotto Corp., SRL (“ILC”) from September 30, 2006 to November 30, 2006.  ILC is a member of a consortium agreement with certain charities in Peru which gives them the right to participate in the operation of a lottery.  The Company’s option to acquire 69% of the shares of ILC was granted as consideration for approximately $15.5 million of advances made to ILC since December 2003.

 

(3)    Operating Segment Information

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”), defines operating segments to be those components of a business for which separate financial information is available that is regularly evaluated by management in making operating decisions and in assessing performance. SFAS No. 131 further requires that segment information be presented consistently with the basis and manner in which management internally disaggregates financial information for the purposes of assisting in making internal operating decisions.

As previously reported in its Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, the Company determined that its previously reported segments consisting of Lottery, Pari-mutuel, Venue Management and Telecommunications Products no longer reflected the way the Company managed the business. Beginning in the first quarter of 2006, the Company began reporting its business in three segments – Printed Products, Lottery Systems and Diversified Gaming. The Printed Products segment includes the instant lottery ticket business and the pre-paid phone card business (formerly the Telecommunications Product Group). The Lottery Systems segment includes the Company’s online lottery business. The Diversified Gaming segment includes the Company’s pari-mutuel wagering systems business (formerly the Pari-mutuel Group) and the Company’s off-track wagering business (formerly the Venue Management Group). All prior period amounts have been restated to conform to the current segment reporting format.

The Printed Products Group provides instant ticket and related services that 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 and includes prepaid phone cards for cellular phone service providers. The Lottery Systems Group offers online, instant and video lottery products and online and instant ticket validation systems. Its business includes the supply of transaction processing software for the accounting and validation of both instant and online lottery games, point-of-sale terminal hardware sales, central site computers and communication hardware sales, and ongoing support and maintenance for these products.  The Diversified Gaming Group provides computerized wagering systems and services such as race simulcasting and communications services and telephone and internet account wagering to the pari-mutuel wagering industry. It owns and operates licensed pari-mutuel wagering facilities in Connecticut, Maine and the Netherlands.  Additionally, with the acquisition of Global Draw, this division is a supplier of fixed odd betting terminals and systems, and interactive sports betting terminals and systems throughout Europe.

9




In the quarter ended September 30, 2006, the Company recorded a $10,200 charge in its Diversified Gaming segment related to the impairment of certain hardware and software assets in the pari-mutuel business as a result of the roll-out of our new terminal and two Quantum Data Centers and the write-off of hardware and accrual of losses of $500 on certain under-performing pari-mutual contracts.  Of this amount, approximately $9,700 was recorded as depreciation and amortization and approximately $500 was recorded as cost of services in the Company’s Statement of Operations for the quarter ended September 30, 2006.

The following tables represent revenues, profits, depreciation, amortization, and capital expenditures for the three and nine month periods ended September 30, 2005 and 2006, by current reportable segments.  Corporate expenses, interest expense and other (income) deductions are not allocated to the reportable segments. All prior period amounts have been restated to reflect the current reportable segments.

 

 

Three Months Ended September 30, 2005

 

 

 

(Unaudited)

 

 

 

Printed 
Products 
Group

 

Lottery 
Systems 
Group

 

Diversified 
Gaming 
Group

 

Totals

 

Service revenues

 

$

79,107

 

42,318

 

34,500

 

155,925

 

Sales revenues

 

16,854

 

21,760

 

2,285

 

40,899

 

Total revenues

 

95,961

 

64,078

 

36,785

 

196,824

 

 

 

 

 

 

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

40,669

 

21,700

 

24,587

 

86,956

 

Cost of sales (exclusive of depreciation and amortization)

 

12,185

 

15,742

 

2,137

 

30,064

 

Selling, general and administrative expenses

 

10,698

 

7,159

 

6,472

 

24,329

 

Depreciation and amortization

 

4,547

 

8,829

 

3,460

 

16,836

 

Segment operating income

 

$

27,862

 

10,648

 

129

 

38,639

 

Unallocated corporate expense

 

 

 

 

 

 

 

7,454

 

Consolidated operating income

 

 

 

 

 

 

 

$

31,185

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

1,676

 

35,063

 

6,645

 

43,384

 

 

10




 

 

 

Three Months Ended September 30, 2006

 

 

 

(Unaudited)

 

 

 

Printed 
Products 
Group

 

Lottery 
Systems 
Group

 

Diversified
Gaming 
Group

 

Totals

 

Service revenues

 

$

91,135

 

50,877

 

56,909

 

198,921

 

Sales revenues

 

10,619

 

7,205

 

645

 

18,469

 

Total revenues

 

101,754

 

58,082

 

57,554

 

217,390

 

 

 

 

 

 

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

46,906

 

27,937

 

32,422

 

107,265

 

Cost of sales (exclusive of depreciation and amortization)

 

8,656

 

3,846

 

904

 

13,406

 

Selling, general and administrative expenses

 

10,894

 

7,284

 

5,170

 

23,348

 

Depreciation and amortization

 

6,640

 

13,270

 

16,247

 

36,157

 

Segment operating income

 

$

28,658

 

5,745

 

2,811

 

37,214

 

Unallocated corporate expense

 

 

 

 

 

 

 

11,595

 

Consolidated operating income

 

 

 

 

 

 

 

$

25,619

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

5,262

 

19,364

 

4,040

 

28,666

 

 

 

 

Nine Months Ended September 30, 2005

 

 

 

(Unaudited)

 

 

 

Printed 
Products 
Group

 

Lottery 
Systems 
Group

 

Diversified 
Gaming 
Group

 

Totals

 

Service revenues

 

$

246,050

 

125,096

 

101,400

 

472,546

 

Sales revenues

 

53,518

 

46,579

 

6,161

 

106,258

 

Total revenues

 

299,568

 

171,675

 

107,561

 

578,804

 

 

 

 

 

 

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

126,300

 

63,139

 

70,198

 

259,637

 

Cost of sales (exclusive of depreciation and amortization)

 

39,073

 

31,928

 

4,840

 

75,841

 

Selling, general and administrative expenses

 

30,206

 

20,037

 

13,505

 

63,748

 

Depreciation and amortization

 

13,365

 

23,764

 

10,736

 

47,865

 

Segment operating income

 

$

90,624

 

32,807

 

8,282

 

131,713

 

Unallocated corporate expense

 

 

 

 

 

 

 

22,053

 

Consolidated operating income

 

 

 

 

 

 

 

$

109,660

 

 

 

 

 

 

 

 

 

 

 

Assets at September 30, 2005

 

$

455,325

 

361,575

 

121,407

 

938,307

 

Unallocated assets at September 30, 2005

 

 

 

 

 

 

 

210,949

 

Consolidated assets at September 30, 2005

 

 

 

 

 

 

 

$

1,149,256

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

5,676

 

68,166

 

12,975

 

86,817

 

 

11




 

 

 

Nine Months Ended September 30, 2006

 

 

 

(Unaudited)

 

 

 

Printed 
Products 
Group

 

Lottery 
Systems 
Group

 

Diversified 
Gaming 
Group

 

Totals

 

Service revenues

 

$

285,329

 

160,253

 

144,531

 

590,113

 

Sales revenues

 

36,558

 

34,313

 

4,172

 

75,043

 

Total revenues

 

321,887

 

194,566

 

148,703

 

665,156

 

 

 

 

 

 

 

 

 

 

 

Cost of services (exclusive of depreciation and amortization)

 

145,892

 

89,304

 

85,612

 

320,808

 

Cost of sales (exclusive of depreciation and amortization)

 

28,635

 

24,299

 

4,264

 

57,198

 

Selling, general and administrative expenses

 

33,099

 

22,812

 

12,145

 

68,056

 

Depreciation and amortization

 

17,966

 

34,804

 

25,742

 

78,512

 

Segment operating income

 

$

96,295

 

23,347

 

20,940

 

140,582

 

Unallocated corporate expense

 

 

 

 

 

 

 

35,087

 

Consolidated operating income

 

 

 

 

 

 

 

$

105,495

 

 

 

 

 

 

 

 

 

 

 

Assets at September 30, 2006

 

$

517,086

 

549,447

 

376,361

 

1,442,894

 

Unallocated assets at September 30, 2006

 

 

 

 

 

 

 

186,329

 

Consolidated assets at September 30, 2006

 

 

 

 

 

 

 

$

1,629,223

 

 

 

 

 

 

 

 

 

 

 

Capital and wagering systems expenditures

 

$

16,121

 

71,152

 

21,864

 

109,137

 

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

 

 

Three Months Ended September 30,

 

Nine Months Ended Septemer 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Reported consolidated operating income

 

$

31,185

 

25,619

 

$

109,660

 

105,495

 

Interest expense

 

7,139

 

12,154

 

20,361

 

30,471

 

Equity in net (income) loss of joint ventures

 

60

 

(1,722

)

1,558

 

(6,455

)

Other income, net

 

(530

)

10

 

(1,252

)

(859

)

Income before income tax expense

 

$

24,516

 

15,177

 

$

88,993

 

82,338

 

 

12




In evaluating financial performance, the Company focuses on operating profit as a segment’s measure of profit or loss. Operating profit is before investment income, interest expense, equity in net (income) loss in joint ventures, corporate expenses and income taxes. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies (see Note 1 of the Company’s Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005).

Providing information on the revenues from external customers for each product and service is impractical.

 

(4)            Income Tax Expense

The effective tax rates for the three and nine months ended September 30, 2006 of 24.0% and 28.5%, respectively, were determined using an estimated annual effective tax rate, which was less than the federal statutory rate of 35% due to lower tax rates applicable to the Company’s operations outside the United States and the tax benefit of the 2004 debt restructuring.  The effective income tax rates for the three and nine months ended September 30, 2005 of 21.7% and 27.0%, respectively, differed from the federal statutory rate due to benefits from expanded business outside the United States, the 2004 debt restructuring and increased research and development activities.

(5)            Comprehensive Income

The following presents a reconciliation of net income to comprehensive income for the three and nine month periods ended September 30, 2005 and 2006:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Net income

 

$

19,185

 

11,527

 

$

64,964

 

58,874

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency translation

 

213

 

4,071

 

(8,439

)

22,787

 

Unrealized loss (gain) on investments

 

131

 

(17

)

1,776

 

(528

)

Other comprehensive income (loss)

 

344

 

4,054

 

(6,663

)

22,259

 

Comprehensive income

 

$

19,529

 

15,581

 

$

58,301

 

81,133

 

 

(6)            Inventories

Inventories consist of the following:

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Parts and work-in-process

 

$

20,694

 

35,982

 

Finished goods

 

19,454

 

27,895

 

 

 

$

40,148

 

63,877

 

 

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.

13




(7)            Accrued Liabilities

Accrued liabilities consist of the following:

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Compensation and benefits

 

$

21,992

 

18,253

 

Customer advances

 

6,667

 

3,066

 

Deferred revenue

 

8,873

 

12,703

 

Taxes, other than income

 

4,489

 

5,947

 

Accrued licenses

 

5,396

 

2,923

 

Liabilities assumed in business combinations

 

 

23,469

 

Accrued contract costs

 

9,461

 

11,823

 

Other

 

23,427

 

40,439

 

 

 

$

80,305

 

118,623

 

 

(8)   Long-Term Debt

On September 30, 2006, the Company had approximately $88,208 available for borrowing under the Company’s revolving credit facility under the July 2006 Amended and Restated Credit Agreement.   There were $155,500 of borrowings and $56,292 in letters of credit outstanding under the revolving credit facility at September 30, 2006.

On July 7, 2006, the Company amended (the “Amendment”) its existing Credit Agreement dated as of December 31, 2004, as amended and restated as of March 31, 2006 (the “March 2006 Amended and Restated Credit Agreement”), to provide for a new $150 million senior secured term loan (the “Term Loan D”) and to make certain other changes to the March 2006 Amended and Restated Credit Agreement (the March 2006 Amended and Restated Credit Agreement and the Amendment are collectively referred to as the “July 2006 Amended and Restated Credit Agreement”). The proceeds from the Term Loan D were used to repay, in full, the remaining $98.5 million of existing Term Loan B and to pay down approximately $51 million of borrowings under the Company’s existing revolving credit facility  The interest rate with respect to the Term Loan D will vary, depending upon the Company’s consolidated leverage ratio, from 75 basis points to 150 basis points above LIBOR for eurocurrency loans and from zero basis points to 50 basis points above the higher of (i) the prime rate or (ii) the Federal Funds Effective Rate plus 0.50%, for base rate loans.  The Company paid approximately $0.5 million in banking, legal and other fees in connection with the Amendment.  The July 2006 Amended and Restated Credit Agreement will terminate on December 23, 2009.

The July 2006 Amended and Restated 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 July 2006 Amended and Restated 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 until December 2009.  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 Generally Accepted Accounting Principles (“GAAP”) as of the last day of the fiscal quarter for which such determination is being made to (y) Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) for the four consecutive fiscal quarters ended on the last day of the fiscal quarter for which such determination is being made.

·       A maximum Consolidated Senior Debt Ratio of 2.50 until December 2009.  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 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

14




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 Interest Coverage Ratio of 3.50 until December 2009. Consolidated Interest 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 total interest expense less non-cash amortization costs included in interest expense.

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 its covenants as of March 31, 2006, June 30, 2006 and September 30, 2006.

15




(9)            Goodwill and Intangible Assets

The following disclosure presents certain information regarding the Company’s acquired intangible assets as of December 31, 2005 and September 30, 2006.  Amortizable intangible assets are amortized over their estimated useful lives, as indicated below, with no estimated residual values. For the three and nine months ended September 30, 2006, intangible assets were impacted by foreign currency translation adjustments of approximately $400 and $700, respectively.

Intangible Assets

 

Weighted 
Average 
Amortization 
Period

 

Gross Carrying 
Amount

 

Accumulated 
Amortization

 

Net Balance

 

Balance at December 31, 2005

 

 

 

 

 

 

 

 

 

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Patents

 

15

 

$

5,201

 

811

 

4,390

 

Customer lists

 

14

 

18,813

 

8,804

 

10,009

 

Customer service contracts

 

15

 

3,793

 

1,392

 

2,401

 

Licenses

 

4

 

14,458

 

6,906

 

7,552

 

Lottery contracts

 

5

 

31,902

 

13,441

 

18,461

 

 

 

 

 

74,167

 

31,354

 

42,813

 

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

 

 

 

$

129,080

 

41,791

 

87,289

 

 

 

 

 

 

 

 

 

 

 

Balance at September 30, 2006

 

 

 

 

 

 

 

 

 

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Patents

 

14

 

$

8,586

 

1,061

 

7,525

 

Customer lists

 

10

 

28,139

 

11,039

 

17,100

 

Customer service contracts

 

15

 

3,546

 

1,756

 

1,790

 

Licenses

 

4

 

26,389

 

10,990

 

15,399

 

Intellectual property

 

4

 

20,804

 

2,712

 

18,092

 

Lottery contracts

 

5

 

34,920

 

18,222

 

16,698

 

 

 

 

 

122,384

 

45,780

 

76,604

 

Non-amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Tradename

 

 

 

37,873

 

2,118

 

35,755

 

Connecticut off-track betting system operating right

 

 

 

34,319

 

8,319

 

26,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

72,192

 

10,437

 

61,755

 

Total intangible assets

 

 

 

$

194,576

 

56,217

 

138,359

 

 

 

16




The aggregate intangible amortization expense for the three month periods ended September 30, 2005 and 2006 was approximately $2,900 and $5,900, respectively.  The aggregate intangible amortization expense for the nine month periods ended September 30, 2005 and 2006 was approximately $8,200 and $14,100, respectively.

The table below reconciles the change in the carrying amount of goodwill, by reporting segment, for the period from January 1, 2006 to September 30, 2006.  In 2006, the Company recorded (a) a $489 increase in goodwill associated with the final purchase price valuation and allocation adjustments of Promo-Travel International, Inc., (b) a $618 decrease in goodwill associated with the acquisition of IGT OnLine Entertainment Systems, Inc., (c) a $314 decrease in goodwill associated with the acquisition of the remaining 35% minority interest in Scientific Games Latin America S.A., (d) a $78,404 increase in goodwill in connection with the acquisition of the online assets of EssNet, (e) a $56 increase in goodwill for the acquisition of an off-track betting operation, (f) a $147,891 increase in goodwill for the acquisition of Global Draw, (g) a $2,247 increase in goodwill for the acquisition of Printer Associates International and (g) a $7,458 increase in goodwill, as a result of foreign currency translation.

Goodwill

 

Printed 
Products 
Group

 

Lottery 
Systems 
Group

 

Diversified
Gaming 
Group

 

Totals

 

Balance at December 31, 2005

 

$

243,439

 

95,115

 

615

 

339,169

 

Adjustments:

 

3,045

 

80,542

 

152,026

 

235,613

 

Balance at September 30, 2006

 

$

246,484

 

175,657

 

152,641

 

574,782

 

(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 certain 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 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 following table sets forth the combined amount of net periodic benefit cost recognized for the three and nine month periods ended September 30, 2005 and 2006:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Components of net periodic pension benefit cost:

 

 

 

 

 

 

 

 

 

Service cost

 

$

814

 

547

 

$

2,441

 

1,642

 

Interest cost

 

788

 

551

 

2,363

 

1,653

 

Expected return on plan assets

 

(625

)

(562

)

(1,876

)

(1,685

)

Actuarial loss

 

419

 

275

 

1,258

 

826

 

Net amortization and deferral

 

16

 

20

 

48

 

60

 

Amortization of prior service costs

 

192

 

 

576

 

 

Net periodic cost

 

$

1,604

 

831

 

$

4,810

 

2,496

 

 

17




The Company previously disclosed in its financial statements for the year ended December 31, 2005, that it expected to contribute approximately $2,500 to its defined benefit pension plans in 2006. As of September 30, 2006, approximately $1,000 and $20 of contributions to the U.K. Plan and U.S. Plan, respectively, have been made. The Company presently anticipates contributing an additional $1,480 of contributions to its defined benefit pension plans, in 2006.

(11)     Stockholders’ Equity

At September 30, 2006, 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.

(12)  Stock-Based Compensation

On January 1, 2006, the Company adopted, using the modified prospective application, Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options and shares purchased under an employee stock purchase plan (if certain parameters are not met), to be recognized in the financial statements based on their fair values and did not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS 123, “Accounting for Stock Based Compensation” (“SFAS 123”), as originally issued and Emerging Issues Task Force (“EITF”) 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” SFAS 123(R) did not address the accounting for employee share ownership plans, which are subject to Statement of Position (“SOP”) 93-6, “Employers’ Accounting for Employee Stock Ownership Plans.”  Under the modified prospective method the Company’s prior interim periods and prior fiscal year financial statements will not reflect any restated amounts for the adoption of SFAS 123(R).

Upon its adoption of SFAS 123(R), the Company began recording compensation cost related to the continued vesting of all stock options that remained unvested as of January 1, 2006, as well as for all stock options granted, modified or cancelled after the Company’s adoption date. The compensation cost to be recorded is based on the fair value at the grant date. The adoption of SFAS 123(R) did not have an effect on the Company’s recognition of compensation expense relating to the vesting of restricted stock grants.

Prior to the adoption of SFAS 123(R), cash flows resulting from the tax benefit related to equity-based compensation was presented in the Company’s operating cash flows, along with other tax cash flows, in accordance with the provisions of EITF 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option,” (“EITF 00-15”). SFAS 123(R) superseded EITF 00-15, amended SFAS 95, “Statement of Cash Flows,” and requires tax benefits relating to excess equity-based compensation deductions to be prospectively presented in the Company’s statement of cash flows as financing cash inflows.

The effect of adopting SFAS 123(R) on the Company’s income from operations, income before income taxes, net income, net cash provided by operating activities, net cash provided by financing activities, and basic and diluted earnings per share for the three and nine month periods ended September 30, 2006, is as follows (in thousands, except per share data):

18




 

 

 

Three Months
Ended
September 30,
2006

 

Nine Months
Ended
September 30,
2006

 

Income from operations, as reported

 

$

25,619

 

$

105,495

 

Effect of adopting SFAS 123(R) on income from operations

 

2,635

 

9,796

 

Income from operations

 

$

28,254

 

$

115,291

 

 

 

 

 

 

 

Income before income taxes, as reported

 

$

15,177

 

$

82,338

 

Effect of adopting SFAS 123(R) on income before income taxes

 

2,635

 

9,796

 

Income before income taxes

 

$

17,812

 

$

92,134

 

 

 

 

 

 

 

Net income, as reported

 

$

11,527

 

$

58,874

 

Effect of adopting SFAS 123(R) on net income

 

1,710

 

6,358

 

Net income

 

$

13,237

 

$

65,232

 

 

 

 

 

 

 

Net cash provided by operating activities, as reported

 

$

13,293

 

$

103,536

 

Effect of adopting SFAS 123(R) on net cash provided by operating activities

 

2,115

 

10,845

 

Net cash provided by operating activities

 

$

15,408

 

$

114,381

 

 

 

 

 

 

 

Net cash provided by financing activities, as reported

 

$

25,184

 

$

317,986

 

Effect of adopting SFAS 123(R) on net cash provided by financing activities

 

(405

)

(4,487

)

Net cash provided by financing activities

 

$

24,779

 

$

313,499

 

 

 

 

 

 

 

Net income per share, as reported:

 

 

 

 

 

Basic

 

$

0.13

 

0.65

 

Diluted

 

$

0.12

 

0.62

 

 

 

 

 

 

 

Effect of adopting SFAS 123(R) on net income per share:

 

 

 

 

 

Basic

 

$

0.01

 

0.07

 

Diluted

 

$

0.02

 

0.07

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic

 

$

0.14

 

0.72

 

Diluted

 

$

0.14

 

0.69

 

Prior to its adoption of SFAS 123(R), the Company accounted for equity-based compensation under the provisions and related interpretations of Accounting Principles Board (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Accordingly, the Company was not required to record compensation expense when stock options were granted to its employees as long as the exercise price was not less than the fair market value of the stock at the grant date. Also, the Company was not required to record compensation expense when the Company issued common stock under its Employee Stock Purchase Plan as long as the purchase price was not less than 85% of the fair market value of the Company’s common stock on the grant date. In October 1995, FASB issued SFAS 123, which allowed the Company to continue to follow the guidelines of APB 25, but required pro-forma disclosures of net income and earnings per share as if the Company had adopted the provisions of SFAS 123. In December 2002, the FASB issued SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB 123,” which provided alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for equity-based employee compensation. The Company continued to account for equity-based compensation under the provisions of APB 25 using the intrinsic value method.

19




Had compensation cost for the Company’s equity-based compensation plans been determined based on the fair value at the grant dates for awards under those plans in accordance with the provisions of SFAS 123, the Company’s net income and net income per share for the three and nine month periods ended September 30, 2005, would have been as follows (in thousands, except per share data):

 

 

Three Months
Ended
September 30,
2005

 

Nine Months 
Ended
September 30,
2005

 

Net income, as reported

 

$

19,185

 

64,964

 

Equity-based compensation included in net income, as reported

 

52

 

155

 

Equity-based compensation under SFAS 123

 

(2,811

)

(6,588

)

Pro forma net income

 

$

16,426

 

58,531

 

 

 

 

 

 

 

Reported net income per share:

 

 

 

 

 

Basic

 

$

0.21

 

0.73

 

Diluted

 

$

0.21

 

0.70

 

 

 

 

 

 

 

Pro forma net income per share:

 

 

 

 

 

Basic

 

$

0.19

 

0.67

 

Diluted

 

$

0.18

 

0.65

 

The Company grants stock options to employees and directors under the Company’s equity incentive plans at not less than the fair market value of the stock at the date of grant. Options granted over the last several years have generally been exercisable in four or five equal installments beginning on the first anniversary of the date of grant with a maximum term of ten years.

The Company grants restricted stock units to employees and directors under the Company’s equity incentive plans. Restricted stock units have only been granted over the last year and have generally been exercisable in five equal installments beginning on the first anniversary of the date of grant with a maximum term of five years.

20




Stock Options

A summary of the changes in stock options outstanding under the Company’s equity-based compensation plans in 2006 is presented below:

 

 

Number of
Options

 

Weighted 
Average 
Remaining
Contract 
Term 
(Years)

 

Weighted 
Average 
Exercise 
Price

 

Aggregate 
Intrinsic 
Value

 

 

 

(In thousands except share price and year)

 

 

 

 

 

 

 

 

 

 

 

Options outstanding at December 31, 2005

 

9,701

 

 

 

$

15.52

 

$

 

Granted

 

405

 

 

 

31.76

 

 

Exercised

 

(1,241

)

 

 

7.27

 

31,523

 

Canceled

 

(772

)

 

 

26.79

 

 

Options outstanding at March 31, 2006

 

8,093

 

7.1

 

$

16.54

 

$

149,610

 

Granted

 

155

 

 

 

37.04

 

 

Exercised

 

(148

)

 

 

13.42

 

3,657

 

Canceled

 

(30

)

 

 

21.16

 

 

Options outstanding at June 30, 2006

 

8,070

 

6.8

 

$

16.98

 

$

144,007

 

Granted

 

25

 

 

 

33.06

 

 

Exercised

 

(123

)

 

 

9.10

 

2,502

 

Canceled

 

(36

)

 

 

15.87

 

 

Options outstanding at September 30, 2006

 

7,936

 

6.6

 

$

17.16

 

$

116,217

 

 

 

 

 

 

 

 

 

 

 

Options excercisable at

 

 

 

 

 

 

 

 

 

March 31, 2006

 

3,001

 

4.8

 

$

7.49

 

$

82,659

 

June 30, 2006

 

3,080

 

4.5

 

$

7.39

 

$

84,492

 

September 30, 2006

 

3,158

 

4.5

 

$

8.46

 

$

73,690

 

 

 

 

Three Months 
Ended 
September 30, 
2006

 

Nine Months 
Ended 
September 30, 
2006

 

 

 

 

 

 

 

Weighted average per-share fair value of options granted during the period

 

$

13.57

 

13.80

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.  The weighted average assumptions used in the model are outlined in the following table:

21




 

 

Nine Months Ended

 

 

 

September 30, 2006

 

 

 

 

 

Assumptions:

 

 

 

Expected volatility

 

33

%

Risk-free interest rate

 

4.4% - 5.2

%

Dividend yield

 

%

Expected life (in years)

 

6

 

The computation of the expected volatility is based on historical daily stock price over a term less than the expected term. A timeframe was used that provided a better representation of the current and future expected volatility. Expected life is based on annual historical employee exercise behavior of option grants with similar vesting periods and option expiration data. The risk-free interest rate is based on the yield of zero-coupon U.S. Treasury securities over the expected term of the option. There are no dividends to be paid.

For the three and nine month periods ended, September 30, 2006, the Company recognized equity-based compensation expense of approximately $2,600 and $9,800, respectively, related to the vesting of stock options and the related tax benefit of approximately $1,000 and $3,200, respectively.  At September 30, 2006, the Company had unearned compensation of approximately $37,000 relating to stock option awards that will be amortized over a weighted-average period of approximately two years. At September 30, 2006, the Company had 2,100 options and restricted stock units available to be granted under its equity-based compensation plans.

Restricted Stock Units

A summary of the changes in restricted stock units outstanding under the Company’s equity compensation plans in 2006 is presented below:

 

Number of 
Restricted 
Stock

 

Weighted 
Average 
Grant Date 
Fair Value

 

 

 

(In thousands except share price)

 

 

 

 

 

 

 

Non-vested shares at December 31, 2005

 

363

 

$

27.57

 

Granted

 

541

 

30.84

 

Canceled

 

(2

)

28.11

 

Non-vested shares at March 31, 2006

 

902

 

$

29.53

 

Granted

 

124

 

38.08

 

Canceled

 

(2

)

27.68

 

Non-vested shares at June 30, 2006

 

1,024

 

$

30.67

 

Granted

 

251

 

29.16

 

Exercised

 

(9

)

30.14

 

Canceled

 

(2

)

27.68

 

Non-vested shares at September 30, 2006

 

1,264

 

$

30.37

 

 

22




For the three and nine months ended September 30, 2006, the Company recognized equity-based compensation expense of approximately $2,000 and $4,200, respectively, related to the vesting of restricted stock units and the related tax benefit of approximately $700 and $1,700, respectively.  At September 30, 2006, the Company had unearned compensation of approximately $31,000 relating to restricted stock units that will be amortized over a weighted-average period of approximately two years.

Employee Stock Purchase Plan

In 2002, the Company adopted, and its stockholders approved, an Employee Stock Purchase Plan (“ESPP”) under which a total of up to 1,000 shares of Class A Common Stock may be purchased by eligible employees under offerings made by the Company each January 1 and July 1. Employees participate through payroll deductions up to a maximum of 15% of eligible compensation. The term of each offering period is six months and shares are purchased on the last day of the offering period at a discount on the stock’s market value. Under an amendment to the ESPP adopted in 2005, the purchase price for offering periods beginning in 2006 will represent a 15% discount on the closing price of the stock on the last day of the offering period (rather than a 15% discount on the lower of (x) the closing price of the stock on the first day of the offering period and (y) the closing price of the stock on the last day of the offering period).  The Company issued 18 shares under the ESPP during the quarter ended June 30, 2006.

(13)  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 July 2006 Amended and Restated Credit Agreement are fully, unconditionally and jointly and severally guaranteed by substantially all of the Company’s 100% owned domestic subsidiaries (the “Guarantor Subsidiaries”).

Presented below is condensed consolidating financial information for (i) Scientific Games Corporation (the “Parent Company”), (ii) the 100% owned Guarantor Subsidiaries and (iii) the 100% owned foreign subsidiaries and the non-100% owned domestic and foreign subsidiaries (collectively, the “Non-Guarantor Subsidiaries”) as of December 31, 2005 and September 30, 2006 and for the three and nine months ended September 30, 2005 and 2006.  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 July 2006 Amended and Restated Credit Agreement, 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.

Scientific Games Management Corporation has been reclassified from the Parent Company to the Guarantor Subsidiaries for the three and nine months ended September 30, 2005.

23




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET

December 31, 2005
(Unaudited, in thousands)

 

 

 

Parent 
Company

 

Guarantor 
Subsidiaries

 

Non-
Guarantor 
Subsidiaries

 

Eliminating 
Entries

 

Consolidated

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

 

15,575

 

23,367

 

 

38,942

 

Accounts receivable, net

 

 

98,704

 

30,585

 

(39

)

129,250

 

Inventories

 

 

29,653

 

10,920

 

(425

)

40,148

 

Other current assets

 

4,938

 

22,102

 

19,173

 

 

46,213

 

Property and equipment, net

 

 

261,027

 

105,759

 

(567

)

366,219

 

Investment in subsidiaries

 

417,182

 

187,577

 

(26,482

)

(578,277

)

 

Goodwill

 

183

 

300,015

 

38,971

 

 

339,169

 

Intangible assets

 

 

74,638

 

12,651

 

 

87,289

 

Other assets

 

11,446

 

91,140

 

28,798

 

(6,101

)

125,283

 

Total assets

 

$

433,749

 

1,080,431

 

243,742

 

(585,409

)

1,172,513

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current installments of long-term debt

 

$

1,000

 

 

5,055

 

 

6,055

 

Current liabilities

 

(7,465

)

96,259

 

46,398

 

115

 

135,307

 

Long-term debt, excluding current installments

 

573,000

 

 

1,680

 

 

574,680

 

Other non-current liabilities

 

(13,673

)

61,143

 

22,162

 

6

 

69,638

 

Intercompany balances

 

(698,987

)

658,194

 

40,793

 

 

 

Stockholders’ equity

 

579,874

 

264,835

 

127,654

 

(585,530

)

386,833

 

Total liabilities and stockholders’ equity

 

$

433,749

 

1,080,431

 

243,742

 

(585,409

)

1,172,513

 

24




SCIENTIFIC GAMES CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET
September 30, 2006
(Unaudited, in thousands)

 

 

Parent 
Company

 

Guarantor 
Subsidiaries

 

Non-
Guarantor 
Subsidiaries

 

Eliminating 
Entries

 

Consolidated

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

 

(4,703

)

42,520

 

 

37,817

 

Accounts receivable, net

 

 

108,853

 

53,150

 

 

162,003

 

Inventories

 

 

52,473

 

11,829

 

(425

)

63,877

 

Other current assets

 

18,620

 

24,540

 

24,668

 

 

67,828

 

Property and equipment, net

 

 

296,943

 

136,074

 

(600

)

432,417

 

Investment in subsidiaries

 

706,673

 

194,548

 

85,745

 

(986,966

)

 

Goodwill

 

183

 

302,133

 

272,466

 

 

574,782

 

Intangible assets

 

 

97,000

 

41,359

 

 

138,359

 

Other assets

 

11,149

 

102,922

 

43,355

 

(5,286

)

152,140

 

Total assets

 

$

736,625

 

1,174,709

 

711,166

 

(993,277

)

1,629,223

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current installments of long-term debt

 

$

2,500

 

 

756

 

 

3,256

 

Current liabilities

 

7,987

 

73,137

 

90,274

 

79

 

171,477

 

Long-term debt, excluding current installments

 

877,125

 

 

1,390

 

 

878,515

 

Other non-current liabilities

 

(15,464

)