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)

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

 

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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.

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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.

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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.

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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.

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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

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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

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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.

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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

 

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		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

 

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		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

 

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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:

 

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.

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(7)            Accrued Liabilities

Accrued liabilities consist of the following:

 

(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

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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.

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(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

 

 

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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

 

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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):

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